Volatile urbanism and the fiscal federalism failure: Why intergovernmental transfer systems are calibrated for a world that no longer exists

Why transfer systems fail under urban volatility

The COVID-19 pandemic offered a partial preview as cities accounting for disproportionate shares of national output absorbed concentrated demand collapses in precisely those revenue-elastic sectors, notably sales taxes, tourism levies, and commercial property revenues, that form the discretionary fiscal base of urban local governments. Research across 150 US cities estimated revenue shortfalls of between 5.5% and 9% in fiscal year 2021 (Chernick et al., 2020). The OECD documented that subnational governments in European countries with higher urban concentration experienced larger asymmetric fiscal impacts, while the intergovernmental transfer systems that were activated in response were not calibrated to the urban geography of the underlying shock (OECD, 2022). Etherington et al. (2022), examining the compounding of COVID-19 and pre-existing fiscal austerity in post-industrial English cities, documented how the combination left local governments structurally unable to deploy transfers toward resilience investment rather than immediate expenditure stabilisation, a pattern that local economy research increasingly identifies as systemic rather than exceptional.

The structural deficiency has three components.

(1) The Formula Mismatch

Transfer formulae are almost universally indexed to population, territorial area, or average per capita fiscal capacity measures. None of these variables captures urban supply chain exposure, energy import dependency, or the concentration of employment in sectors vulnerable to geopolitical disruption. A municipality generating 27% of national GDP, as Nairobi County does according to Kenya’s official Gross County Product statistics (KNBS, 2023), receives transfers computed on population shares that bear no relationship to the scale of its productive exposure or the potential fiscal impact of a supply chain shock. The formula is designed for equity under stability; it has no mechanism to address the amplification of shocks through concentrated urban nodes. Begley et al. (2024), analysing employment shifts across industrial sectors in English regions through dynamic shift-share analysis, found that exogenous economic shocks affect key sectors unevenly and in ways that correlate poorly with population-based measures of fiscal capacity, a finding that directly undermines the equity logic underlying population-indexed transfer formulae. The English experience with fiscal decentralisation reinforces the point: Muldoon-Smith and Greenhalgh (2015) demonstrated that local authorities increasingly reliant on commercially derived revenue streams exhibit precisely the kind of spatially uneven and cyclically volatile fiscal base that volatile urbanism now exposes to compound global shocks, producing geographical variegation that equalisation formulae calibrated under stability assumptions cannot address.

(2) Temporal Mismatch

The timing architecture of transfer systems is incompatible with the speed of urban volatility shocks. Standard equalisation transfer schedules operate on annual or biennial cycles, negotiated through legislative or administrative processes that reflect medium-term fiscal planning assumptions. The Strait of Hormuz closure that began in March 2026 transmitted through urban energy and logistics costs within days (Allam et al., 2026), generating price pressures visible in retail inflation data within weeks (UNCTAD, 2026). No existing intergovernmental transfer framework includes provisions for rapid, shock-contingent disbursement calibrated to the urban geography of the disruption. The mismatch between shock velocity and transfer cadence is not a design flaw of any particular system; it is a category mismatch between the temporal architecture of fiscal federalism and the temporal architecture of geopolitically driven urban disruption.

(3) Conceptual Mismatch

Most critically, the conceptual basis of equalisation transfers is horizontal: the objective is to enable jurisdictions with lower fiscal capacity to deliver comparable public services to those with higher capacity, holding expenditure needs roughly constant. Volatile urbanism generates a different problem, not horizontal inequality between jurisdictions of similar function, but vertical fiscal implosion in the nodes whose collapse has the largest national fiscal multiplier. When a major urban node experiences a supply chain shock, the fiscal loss is not distributed according to population or need; it concentrates in the revenue streams of the jurisdiction that hosted the productive activity, while the expenditure obligation, namely, social protection, emergency services, and infrastructure maintenance, simultaneously increases. The transfer system was designed for the former problem. It cannot address the latter without structural modification.

The flypaper problem under volatility

The fiscal federalism literature has extensively documented the ‘flypaper effect’: the empirical regularity that intergovernmental grants tend to remain in the public sector, stimulating government expenditure rather than being returned to taxpayers through tax relief (Hines and Thaler, 1995; Lago et al., 2024). Under stable conditions, this is a manageable design challenge. Under volatile urbanism, it becomes a systemic risk. When an urban node receives emergency central government transfers following a supply chain shock, those funds are overwhelmingly deployed on immediate expenditure needs, maintaining services and stabilising employment, with negligible residual capacity for the infrastructure investment that would reduce future exposure. The transfer mechanism relieves immediate fiscal stress while leaving intact the structural vulnerability that generated the stress. It is, in this sense, a stability-preserving instrument that systematically prevents the adaptation it claims to support.

The point has recent US empirical support. Clemens et al. (2024), evaluating state fiscal behaviour under the ARPA windfall, found that a substantial share of recovery funds supported recurrent expenditure and end-of-period rainy-day balances rather than investment in structural resilience. Dahan and Strawczynski (2013), writing in this journal on fiscal rules and expenditure composition in OECD countries, observed a parallel dynamic in which transfer-dependent jurisdictions systematically underinvest in capital expenditure relative to current transfers when binding fiscal rules prevail.

This is not unique to any jurisdiction as the OECD’s analysis of subnational government resilience following COVID-19 found that the pandemic ‘significantly reduced the national governments’ fiscal space to support the SNGs in the event of another major shock as extensively as they did during the COVID-19 pandemic’ (De Mello and Teresa, 2022). The implicit logic of the analysis is that the system has now depleted the buffer it used to absorb the last shock, precisely when the next class of shocks, namely, geopolitically driven urban supply chain disruptions of the kind the Hormuz closure exemplifies, is materialising. The OECD further observed that subnational governments facing concurrent expenditure pressure and revenue shortfalls default to reducing discretionary investment, the very investment category most capable of reducing future structural vulnerability (OECD, 2022). Volatile urbanism creates a feedback loop through the fiscal federalism architecture: shocks reduce urban fiscal capacity, transfers fill the gap on recurrent terms, investment in resilience is crowded out, and future shock exposure is unchanged or worsened.

Three redesign principles

Reforming intergovernmental fiscal transfer systems to account for volatile urbanism requires conceptual innovation, not merely incremental adjustment to existing formula parameters.

(i) Volatility-Indexed Revenue Sharing

Revenue-sharing arrangements should incorporate a supply chain exposure coefficient, derived from sector-level input-output analysis and geopolitical vulnerability mapping, that adjusts the transfer entitlement of urban jurisdictions in proportion to the structural volatility of their economic base. Jurisdictions whose dominant sectors depend on geopolitically exposed input corridors, whether energy imports, port logistics, or commodity-dependent manufacturing, would receive a larger baseline transfer allocation, creating a structural buffer rather than a post-shock reactive disbursement. The OECD’s Adapting Intergovernmental Fiscal Transfers for the Future (Dougherty et al., 2024) acknowledged the importance of aligning transfers with emerging policy objectives including environmental sustainability; volatile urbanism provides an analogous rationale for incorporating geopolitical exposure as a transfer-determining variable. The inclusion of energy import dependency as a volatility-weighting variable is further grounded in existing work on the relationship between urban energy structure and metropolitan economic stability: Allam (2020), examining renewable energy adoption in megacities through the lens of fiscal mechanisms, demonstrated that energy diversification and fiscal instrument design are structurally linked, reinforcing the case for energy exposure as a baseline transfer coefficient rather than a post-shock afterthought.

(ii) An Urban Volatility Reserve Facility

Alongside existing equalisation transfer mechanisms, governments should establish a ring-fenced rapid disbursement facility for urban jurisdictions facing supply chain-generated fiscal shocks. Unlike discretionary emergency transfers, disbursement from this facility would be triggered by objective, pre-defined indicators, including energy price thresholds, port throughput declines, or sector-level output contractions exceeding defined magnitudes, reducing the political economy delays that currently prevent timely fiscal support. The IMF’s Resilience and Sustainability Trust provides a partial institutional precedent at the sovereign level; an analogous instrument is needed within the intergovernmental fiscal architecture at the urban level.

(iii) Conditioned Investment Linkage

A share of shock-contingent transfer disbursements should be explicitly conditioned on recipient urban governments producing, within a defined time period, a credible Urban Volatility Reduction Plan, including measurable commitments to energy mix diversification, supply chain redundancy investment, and infrastructure hardening. This addresses the flypaper problem directly: by conditioning a portion of transfers on documented investment in structural resilience rather than permitting full deployment on recurrent expenditure, the mechanism creates fiscal incentives for the adaptation that the current system structurally discourages. Van der Waldt (2018), examining local economic development strategies as instruments for urban resilience, demonstrated empirically that structured linkages between government transfer frameworks and investment in local productive capacity are necessary conditions for durable shock recovery, providing direct support for the conditionality principle advanced here.

Implications for policy design

The argument developed here has implications beyond fiscal federalism, touching the broader architecture of multilevel governance under conditions of compounding global disruption. Fiscal transfer systems are not merely distributive instruments; they are the primary mechanism through which urban economic shocks are absorbed, transmitted, and amplified or dampened across national economies. A transfer architecture that was calibrated for the stable world of the post-war growth era is now operating in an environment structurally different from its design conditions. The result is not simply suboptimal policy; it is a systemic governance failure that leaves the nodes generating the largest share of national output with the least institutional capacity to absorb the disruptions most capable of destabilising them.

The Hormuz closure has made this visible at scale. The IMF’s April 2026 World Economic Outlook projects global growth falling to 3.1% under a reference scenario that assumes short-lived conflict; in an adverse scenario, growth falls to 2.5%, driven substantially through the urban energy and logistics transmission channels that volatile urbanism identifies (IMF, 2026). The fiscal federalism architecture has no systematic mechanism to absorb that transmission at the urban level. That gap is compounded by the structural transformation of urban economic bases catalysed by compound shocks: Allam and Jones (2021), analysing the emergence of new digital urban economies and restructured revenue geographies in the wake of pandemic disruption, demonstrated that post-shock cities develop economic configurations that existing transfer formulae are structurally unable to recognise or respond to. Redesigning the fiscal architecture is not a technical adjustment at the margin of public finance; it is a necessary condition for the long-term viability of decentralised governance under permanent volatility.