Federal funding reaches American cities through three distinct channels: direct transfers, indirect transfers, and what analysts term "fiscal dark matter." Understanding each category is essential to assessing how vulnerable municipalities may be to any future pullback in federal spending — a question that has gained urgency as debates over the federal deficit and debt ceiling intensify, and as pandemic-era aid programs wind down.

Direct transfers are straightforward — funds disbursed directly from the federal government to local governments. A prominent example is the Community Development Block Grant (CDBG) program, which finances public infrastructure and neighborhood services. In 2022, direct transfers of this type totaled $146.3 billion. While substantial, this figure represents the smallest of the three funding categories. Many cities have already been adjusting to the expiration of direct American Rescue Plan Act allocations, which provided $350 billion in flexible relief to state, local, and tribal governments during the pandemic and whose obligated funds are being spent down.

Indirect transfers are less visible but considerably larger. These funds are initially awarded to state governments, which then distribute money to municipal-level programs according to their own budgetary priorities. K-12 education offers a clear illustration: schools receive federal Title I dollars to support teachers and programs, and federal highway funding operates on a similar pass-through model. Altogether in 2022, the federal government transferred $1.1 trillion to state governments. That sum amounted to 36% of total state revenue for the year, with individual state reliance ranging from approximately 22% to 50%. Precisely how much of that money ultimately reached cities is difficult to determine — a transparency gap that itself constitutes a problem, since it makes it hard to establish how exposed local governments are to reductions in federal support for state budgets. This data void also complicates credit analysis for municipal bond issuers, who must assess revenue stability when rating city debt.

The third category — fiscal dark matter — encompasses all federal spending that flows directly into local communities without ever appearing on a municipal budget sheet. This includes housing subsidies such as the Low-Income Housing Tax Credit (LIHTC) and Section 8 rental assistance, as well as food support programs like SNAP and direct funding for local food banks.

When the flow of federal money in this third category begins to dry up, the resulting consequences — whether rightly or wrongly — will land squarely on the mayor's desk. The median voter is unlikely to see a rise in homeless encampments and think to hold the Secretary of Housing and Urban Development responsible. This dynamic creates a mismatch between where policy decisions are made and where political accountability is assigned, potentially pressuring local officials to backfill federal cuts with already strained municipal budgets.

The full analysis is available in the piece by Jeff Fong.

Source: Marginal Revolution