Financial Decentralisation: Empowering Local Governments in India

Financial strength sits at the heart of any meaningful local governance. You can have the best-laid plans for village roads, urban sanitation, or rural water supply, but without the power to raise, allocate, and spend money independently, local bodies become little more than post offices for higher-tier governments. This is where financial decentralisation steps in – a reform principle that aims to put purse strings, not just paper functions, in the hands of Panchayati Raj Institutions (PRIs) and Urban Local Bodies (ULBs).

What financial decentralisation really means 🔗

Financial decentralisation, often called fiscal decentralisation, is the transfer of revenue-raising powers, expenditure responsibilities, and decision-making authority over money from central and state governments to local bodies. It has three practical pillars: the authority to levy and collect local taxes, the devolution of funds from higher levels of government, and autonomy to plan and spend on local priorities. When all three work together, a Gram Panchayat or a Municipal Council can actually function as a government rather than merely as an implementation agency.

The conceptual foundation is straightforward: governance functions are formally assigned by law to local governments, supported by an adequate mix of financial grants and tax handles, along with the staff needed to actually deliver. Remove any of these legs and the stool topples.

Constitutional architecture of fiscal devolution 🔗

The 73rd and 74th Constitutional Amendment Acts of 1992 laid the formal groundwork by giving constitutional status to Panchayats and Municipalities. These amendments mandated that states devolve funds, functions, and functionaries – the famous “three Fs” – to local bodies.

Article 243-I and the State Finance Commission 🔗

The most important institutional mechanism for fiscal decentralisation at the sub-state level is the State Finance Commission (SFC). Under Article 243-I of the Constitution, the Governor of every state is required to constitute an SFC within one year of the 73rd Amendment and every five years thereafter, to review the financial position of Panchayats and Municipalities.

The SFC performs a role for local bodies similar to what the Union Finance Commission performs for the Centre and the states. It recommends how a state’s resources should be divided between the state government and local bodies in terms of taxes, duties, and levies, and how those proceeds should be distributed across the three tiers of Panchayati Raj.

Role of the Union Finance Commission 🔗

The Union Finance Commission, constituted under Article 280, also plays a decisive role. It recommends measures to augment the Consolidated Fund of a state to supplement the resources of Panchayats and Municipalities. With the commencement of the Sixteenth Finance Commission award period from April 2026, there is renewed focus on fiscal decentralisation and the growing financial empowerment of Rural Local Bodies.

Trends from previous Finance Commissions are encouraging. The 15th Finance Commission (2020-26) recommended total grants of ₹2,97,555 crore to Rural Local Bodies, of which ₹2,82,632 crore was actually released – a release efficiency of nearly 95%, the highest ever. States like Assam, Kerala, Mizoram, Tripura, and Uttar Pradesh recorded 100% utilisation.

Sources of revenue for local bodies 🔗

Financial decentralisation cannot be understood without a clear map of where the money actually comes from. Local bodies in India rely on a three-legged revenue structure.

Own-source revenue: the taxes local bodies can levy 🔗

This is the most autonomy-enhancing pillar, because what a local body earns itself, it can spend without waiting for anyone’s approval. For Gram Panchayats, revenue handles typically include taxes on land and buildings not subject to agricultural assessment, taxes on entertainment other than cinematograph shows, taxes on vehicles other than motor vehicles, and taxes on advertisements.

The numbers, however, are sobering. According to a study by the National Institute of Public Finance and Policy, in 2002-03 the own revenues of panchayats constituted just 0.07% of GDP or 0.36% of total revenues raised in the country. Two decades later, the situation has improved modestly but remains deeply skewed.

For Urban Local Bodies, property tax is the backbone of own-source revenue, alongside professional tax, advertisement tax, entertainment tax, user charges for water and sanitation, building permit fees, and rents from municipal properties.

Assigned revenues and shared taxes 🔗

States assign certain revenues to local bodies – for example, a share of stamp duty, motor vehicle tax, or entertainment tax. These transfers are statutory but the rates and composition vary widely from one state to another.

Grants-in-aid from higher levels 🔗

This includes grants from the Union Finance Commission (routed through states), grants from State Finance Commissions, and funds from Centrally Sponsored Schemes. The Union Finance Commission recommends measures to the President to augment state funds so they can supplement the resources of Panchayats and Municipalities.

Why most local bodies remain financially dependent 🔗

Despite three decades of constitutional mandates, fiscal decentralisation in practice has lagged far behind its political and administrative counterparts. The reasons are structural, political, and administrative at the same time.

Narrow and inelastic tax base 🔗

Constitutional provisions and state legislation restrict municipal taxing powers to a limited set of relatively inelastic tax bases. High-yield taxes like GST, income tax, and vehicle registration tax remain outside the jurisdiction of local bodies. Even where ULBs can tax, poor administration and weak enforcement mean significant leakages.

Property tax – underperforming the potential 🔗

Property tax should be the workhorse of urban finance. In reality, collection efficiency rarely exceeds 70%, and in smaller municipalities it can fall below 50%. A World Bank analysis identifies four core problems: undervaluation of properties, incomplete and outdated property registers, policy inadequacies such as too many exemptions, and ineffective administration. Cities like Surat and Hyderabad have shown that GIS-based property mapping can dramatically improve collections, but adoption remains patchy.

State Finance Commissions in poor shape 🔗

On paper, SFCs are the engine of fiscal decentralisation at the state level. In practice, they have become one of the most neglected institutions created by the 73rd and 74th Amendments. A 2023 report tabled before the Lok Sabha highlighted that out of 26 states reporting information, only nine had constituted their Sixth State Finance Commission, and of those only two were actually active – despite the constitutional five-year cycle. States often delay the constitution of SFCs, ignore their recommendations, or fail to place the mandatory Action Taken Reports before the legislature.

Unfunded mandates and vertical imbalance 🔗

Municipalities are responsible for the 18 functions listed in the Twelfth Schedule, yet their share in combined public finances remains below 3% of state and central government expenditure. This gap between responsibilities and resources is the classic definition of an unfunded mandate.

Parallel agencies and diluted authority 🔗

In many cities, town planning stays with development authorities, water and sewerage with specialised boards, and housing with parastatals. Municipal bodies end up with fragmented authority and fragmented revenue – a recipe for weak accountability.

The uneven landscape across states 🔗

Financial decentralisation is not uniform across the country. The Devolution Index prepared by the Indian Institute of Public Administration for the Ministry of Panchayati Raj assesses states on six dimensions including Finances. Karnataka, Kerala, Maharashtra, Tamil Nadu, and Uttar Pradesh score above 60 and are classified as “very high” performers.

Karnataka tops the overall Devolution Index as well as the Finances sub-index, largely because Panchayats there enjoy substantial tax and non-tax powers, and the state releases grants-in-aid from the 15th Finance Commission and SFC recommendations in a timely manner. At the other end, twelve states and union territories still lag significantly behind the national average, showing that constitutional uniformity has not translated into practical uniformity.

Kerala’s People’s Plan – a glimpse of what’s possible 🔗

Kerala’s People’s Plan Campaign, launched in 1996, devolved between 35% and 40% of the state’s plan outlay to local bodies and gave them genuine planning autonomy. The experiment demonstrated that when funds, functions, and functionaries move together, local governments can draft meaningful development plans and execute them. Importantly, this did not happen by accident – it was backed by legislation, trained officials, and a committed political leadership.

Reform pathways 🔗

The direction of reform is reasonably well understood. It is political will, not conceptual clarity, that has been in short supply.

Strengthening local taxation 🔗

Expanding the tax handles available to local bodies is essential. Without local taxation, Gram Panchayats cannot be held accountable to the people who elect them. Reforms such as area-based property tax systems, updated GIS-linked property registers, and reasonable user charges for water and sanitation can substantially boost own revenues.

Making SFCs credible and timely 🔗

States must be held accountable to the five-year constitutional cycle. Commissions should be led by economists and public finance experts rather than staffed purely with bureaucrats and politicians, and Action Taken Reports should be tabled promptly and transparently.

Predictable and performance-linked transfers 🔗

The 15th Finance Commission introduced performance-linked grants, and the 16th Finance Commission is expected to expand this approach. Tying a portion of grants to measurable outcomes – sanitation coverage, water supply, audit compliance – creates a positive feedback loop.

Capacity building at the grassroots 🔗

Fiscal autonomy without financial literacy is meaningless. Training Panchayat secretaries and municipal finance officers in budgeting, double-entry accounting, tax administration, and digital tools is as important as the constitutional provisions themselves.

Why this matters for everyday governance 🔗

Whenever a streetlight stays broken, a borewell runs dry, or a primary health centre goes unstaffed, the chain of causation often ends at a local body without the money or the authority to act. Financial decentralisation is not an abstract public finance debate – it is the mechanism that determines whether the village or neighbourhood you live in gets a say in how public resources are spent. Real democracy needs real fiscal space at the level closest to the citizen.

What do you think? Should states be required to devolve a minimum fixed percentage of their revenue to local bodies, the way the Centre is required to share tax revenue with states? And do you believe smaller municipalities and Gram Panchayats in your area are using even the limited revenue powers they already have effectively?

References

1. https://www.drishtiias.com/daily-updates/daily-news-analysis/democratic-decentralisation-in-india-1
2. https://www.drishtiias.com/daily-updates/daily-news-analysis/state-finance-commission-2
3. https://rviasclasses.com/ias/exams/state-finance-commission-india-role-functions-limitations
4. https://vajiramandravi.com/current-affairs/finance-commission-and-fiscal-decentralisation/
5. https://www.nipfp.org.in/media/medialibrary/2013/08/Fiscal_Decentralization_to_Rural_Local_Governments_in_India.pdf
6. https://en.wikipedia.org/wiki/Finance_Commission
7. https://banotes.org/admin-system-state-district-levels/financial-framework-urban-local-bodies-india-analysis/
8. https://documents1.worldbank.org/curated/en/852151587668989296/pdf/Property-Taxation-in-India-Issues-Impacting-Revenue-Performance-and-Suggestions-for-Reform.pdf
9. https://india.mongabay.com/2023/03/state-finance-commissions-in-poor-shape/
10. https://decentralization.net/2025/02/the-status-of-devolution-to-panchayats-in-india/