It still leads to unsolvable problems like, what is expected when two instances federate content with eachother? What if you use a web app to use a third party instance and it spits out unsanitized data?

If you assume it's part of the API contract, then an evil instance can send you unescaped content and you got an exploit. If you escape it you'll double escape it from well behaved instances. This applies to apps too: now if Voyager for example starts expecting pre-sanitized data from the API, and it makes an API call to an evil instance that doesn't? Bam, you've got yourself potential XSS. There's nothing they can do to prevent it. Either it's inherently unsafe, or safe but will double-escape.

You end up making more vulnerabilities through edge cases than you solve by doing that. Now all an attacker needs to do is find a way to trick you into thinking they have sanitized data when it's not.

The only safe transport for user data is raw. You can never assume any user/remote input is pre-sanitized. Apps, even web ones, shouldn't assume the data is sanitized, they should sanitize it themselves because only then you can guarantee that it will come out correctly, and safely.

This would only work if you own both the server and the UI that serves it. It immediately falls apart when you don't control the entire pipeline from submission to display, and on the fediverse with third party clients and apps and instances, you inherently can't trust anything.