A couple things:
1) I nested this page under Government in the menu as per your first option.
2) If you have a lot of information for this page, then I would go this route.
3) If not, I would group “local government” and “state/federal” on a page with header of “government” and then make a division of those two on that page.

Also, notice the header at the top. It is different from the global header of the website. You can have a inner shadow on the header image and add a color overlay. I picked a yellow with opacity of 0.3. Good thing to have if you want different groups to have a different image/color.