Local governments can expand their debt financing capacity by using land conveyance revenue as a source of guarantee and debt repayment, while improving the efficiency of market resource allocation is an important support for realizing high-quality economic development. This paper first establishes a theoretical framework to show that local government debt expansion exacerbates resource misallocation due to financial friction heterogeneity. Second, using the data of Chinese industrial enterprises combined with the exogenous event of the central government’s deregulation of local government debt financing in 2009, it empirically tests the resource allocation effect of local government debt expansion by using the difference-in-differences method. The study finds that: 1) Local government debt expansion exacerbates the loss of resource allocation efficiency, and this conclusion still holds after a series of robustness tests. 2) The mechanism analysis verifies the hypothesis of the theoretical framework that local government debt expansion relatively raises the financing cost and the marginal return to capital product of private enterprises, which in turn widens the degree of dispersion of inter-sectoral value productivity and exacerbates resource mismatch. 3) Further analysis shows that the resource mismatch induced by local government debt expansion ultimately reduces total factor productivity. The above findings enrich the existing literature on the analysis of the economic effects of local government debt in China, not only expanding the theoretical support, but also providing detailed empirical evidence, which is of certain reference value for preventing and resolving the risks of local government debt and promoting the high-quality development of the economy.