Financial Decentralization: Enhancing Local Financial Autonomy in India

Financial autonomy is the lifeblood of genuine local governance. Without the power to raise, allocate, and spend funds, local bodies remain administrative offices carrying out instructions from above rather than institutions of self-government. Financial decentralization aims to change this by transferring taxation rights, budget authority, and expenditure powers from higher levels of government to Panchayati Raj Institutions (PRIs) and Urban Local Bodies (ULBs). The journey so far has been uneven, with significant constitutional backing but limited on-ground progress in most states.

What financial decentralization really means 🔗

Financial decentralization is the process of devolving fiscal powers to local governments so they can make real decisions about their own communities. It rests on three pillars: the authority to levy and collect taxes, the freedom to design budgets, and the power to decide how money is spent. When these three move together, a Gram Panchayat or Municipal Council can repair a road, hire a sanitation worker, or build a community hall without waiting months for clearances from the state capital.

The 73rd Constitutional Amendment added Part IX to the Constitution and placed 29 subjects within the functional domain of Panchayati Raj bodies through the Eleventh Schedule. The 74th Amendment did the same for municipalities with an additional 18 functional items. Together, these amendments gave local governments a constitutional identity. However, as analysts have observed, the Amendments left implementation, service delivery, and transfer of responsibilities to the discretion of state legislatures, which means expenditure responsibilities expanded without a corresponding guarantee of matching funds.

The constitutional architecture for local finance 🔗

The Constitution lays out a clear framework for how local bodies are meant to be funded. Article 243H empowers state legislatures to authorise Panchayats to levy, collect, and appropriate specific taxes, duties, tolls, and fees. It also provides for the assignment of certain state-level taxes to local bodies, grants-in-aid from the Consolidated Fund of the State, and the establishment of funds for crediting and withdrawing local body money. Article 243I makes it mandatory for every state to constitute a State Finance Commission (SFC) every five years.

Sources of local body finance 🔗

Local bodies have multiple revenue streams. According to the Ministry of Panchayati Raj, these include budgetary allocation from state governments, a share of revenue of certain taxes, collection and retention of self-raised revenue, Central Government programmes and grants, and Union Finance Commission grants under Article 243H. Own-source revenue typically comes from property taxes, professional taxes, water charges, market fees, and licensing fees. Transfers from state and central governments fill the rest of the gap.

The State Finance Commission: A constitutional mediator 🔗

The State Finance Commission is the institutional bridge between state finances and local body finances. It reviews the financial position of Panchayats and Municipalities and recommends how taxes, duties, tolls, and fees should be distributed between the state and local bodies, along with grants-in-aid. In essence, it replicates at the state level what the Union Finance Commission does between the Centre and the states.

Despite this clear mandate, progress on the ground remains sluggish. A Mongabay India report noted that three decades after decentralisation began, only nine states had constituted the 6th SFC, and of these, only two were active at the time of reporting. This delay undermines the very purpose of the constitutional design. An expert quoted in the same report, former NIPFP professor Tapas Sen, observed that progress is nowhere near what was envisaged thirty years ago, with clear resistance to devolving power to local bodies.

Taxation powers at the local level 🔗

Local tax administration is where financial independence either takes root or withers. Under Article 243H, state laws determine which taxes a Panchayat can levy. Common sources include taxes on land and buildings, professional taxes, entertainment taxes, taxes on advertisements, and service fees for water, sanitation, and street lighting. Urban local bodies typically have broader taxation powers, with property tax serving as their financial backbone.

Yet own-source revenue remains strikingly low. RBI data cited by Drishti IAS shows that in FY 2022-23, panchayats recorded a total revenue of Rs 35,354 crore, but only Rs 737 crore came from their own tax revenue. The same source noted that on average, each panchayat earned just Rs 21,000 from its own tax revenue, while Central government grants amounted to approximately Rs 17 lakh per panchayat. This is the paradox at the heart of fiscal decentralization: local bodies have been handed responsibilities but not the fiscal muscle to carry them out independently.

Why own-revenue collection remains weak 🔗

Several factors explain the poor tax performance. Many panchayats lack trained accountants, digital systems, and up-to-date property registers. Political resistance to taxing local residents is strong, particularly in smaller rural bodies where every taxpayer is also a voter. State governments, meanwhile, often hold back on assigning buoyant tax sources to avoid sharing revenue. As an IMF working paper by M. Govinda Rao observed, despite constitutional recognition, local governments in India do not raise significant revenues and remain dependent on higher-level governments, making the arrangement closer to de-concentration than genuine decentralisation.

The role of Union Finance Commission grants 🔗

Union Finance Commissions have progressively increased grants to local bodies. A study commissioned by the 15th Finance Commission noted that the Tenth, Eleventh, and Twelfth Finance Commissions recommended grants for local bodies ranging between 1 to 1.5 percent of the central divisible pool, while the Thirteenth Finance Commission raised this to around 2.5 percent, and the Fourteenth Finance Commission pushed it to nearly 4.5 percent. This upward trajectory reflects a growing recognition that local bodies need reliable, rule-based resources to function as institutions of self-government.

Eleventh and Twelfth Finance Commissions: Early movers 🔗

The Eleventh Finance Commission (2000-05) was the first to operate in the new constitutional regime and began the practice of earmarking untied grants for rural and urban local bodies. The Twelfth Finance Commission (2005-10) continued and expanded this trend, linking part of the grant to audited accounts and basic fiscal discipline. While the sums involved were modest by today’s standards, these two commissions laid the groundwork for predictable, rule-based fiscal transfers to the third tier.

The Fourteenth and Fifteenth Commissions: Scaling up 🔗

The Fourteenth Finance Commission broke new ground by allocating Rs. 2,00,292.20 crore as grants-in-aid to Gram Panchayats in all states covered under Part IX, with an additional Rs. 87,143.80 crore allocated for Urban Local Bodies. The 15th Finance Commission, covering 2021-26, went further still. According to PRS Legislative Research, the total grants to local bodies will be Rs 4.36 lakh crore, including Rs 2.4 lakh crore for rural local bodies, Rs 1.2 lakh crore for urban local bodies, and Rs 70,051 crore for health grants through local governments.

The 15th Commission also introduced important conditions. Entry-level criteria include publishing provisional and audited accounts in the public domain and fixing minimum floor rates for property taxes. PRS also notes a particularly significant requirement: no grants would be released to local bodies of a state after March 2024 if the state does not constitute a State Finance Commission and act upon its recommendations. This conditionality is designed to force lagging states to finally take SFCs seriously.

Tied versus untied grants: The flexibility debate 🔗

Modern Finance Commission grants come in two flavours. Tied grants are earmarked for specific purposes, while untied grants can be spent on local priorities. The Press Information Bureau has noted that untied grants are to be used for location-specific felt needs under the 29 subjects in the Eleventh Schedule, excluding salaries and establishment costs, while tied grants are earmarked for sanitation, maintaining Open Defecation Free status, drinking water supply, rainwater harvesting, and water recycling.

This split serves a dual purpose. Tied grants ensure that national priorities like water and sanitation receive guaranteed funding, while untied grants preserve the spirit of local autonomy. A balance between the two is essential: too much tying makes local bodies mere implementing agencies, while too much untying risks neglect of critical services.

Tangible gains from financial decentralization 🔗

Despite the gaps, financial decentralization has produced real improvements in service delivery. Rural water supply schemes are now being funded directly through the 15th Finance Commission’s tied grants. The Press Information Bureau has reported that Rs 1,42,084 crore has been recommended as a tied grant to rural local bodies for water and sanitation during 2021-22 to 2025-26, significantly strengthening local self-government in line with the 73rd Amendment.

Gram Panchayats can now repair hand pumps, buy sanitation equipment, and purchase LED street lights from their own accounts. Municipalities can contract waste collection services based on local needs. School infrastructure repairs-leaking roofs, broken furniture, boundary walls-no longer require months of file movement to the state secretariat. These might seem like small changes, but they represent a quiet revolution in how governance touches everyday life.

Persistent challenges 🔗

Financial decentralization still faces significant structural problems. Many States delay constituting their Finance Commissions, and even when SFCs submit reports, action-taken memoranda are often tabled years late or not at all. Capacity at the panchayat level remains thin; many accountants are part-time or untrained. Digital record-keeping is patchy, and audit trails are often incomplete.

There is also the question of asymmetry between functions and finances. A Mongabay report quoting economist Pinaki Chakraborty highlights that the asymmetry between functions and finance creates imbalances between state and local bodies as well as across local bodies, and that digitising data in a comparable classification code is crucial for building local-level data across states. The absence of uniform accounting codes makes it nearly impossible to compare fiscal performance across states or to design evidence-based reforms.

The urban-rural divide 🔗

Urban local bodies face their own peculiar challenges. Property tax collection efficiency varies wildly between municipal corporations, and many cities fail to revise their tax base or rates for years. The Reserve Bank of India’s Municipal Finances report has repeatedly flagged these concerns. Rural bodies, by contrast, suffer from narrow tax bases and weak administrative infrastructure. Any serious reform must address both ends of the spectrum differently.

The road ahead 🔗

Strengthening financial decentralization requires action on several fronts. States need to constitute SFCs on time, accept their recommendations, and table action-taken reports promptly. The 16th Finance Commission, which will be operational from 2025, has an opportunity to push a uniform data framework and a model charter for SFCs. Capacity building for panchayat accountants, digital financial management systems, and transparent public disclosure of accounts can together create the foundation for genuine fiscal autonomy.

Equally important is political will at the state level. Devolving functions, functionaries, and finances-the famous three Fs-requires states to voluntarily give up control, something that political systems rarely do willingly. Civil society engagement, citizen awareness, and sustained academic scrutiny all have roles to play in keeping the pressure on.

What do you think? Should local bodies be given the power to independently revise property taxes without state approval, even if it leads to wide variations across regions? How can we ensure that increased Finance Commission grants genuinely translate into better services rather than being absorbed by administrative inefficiencies?

References

1. https://secforuts.mha.gov.in/73rd-amendment-of-panchayati-raj-in-india/
2. https://andhrapradesh.pscnotes.com/appsc-group-1-mains/paper-iii/polity-paper-iii-appsc-group-1-mains/local-governance-73rd-and-74th-constitutional-amendments-types-of-urban-local-bodies-and-panchayati-raj-institutions-in-india-sources-of-finance-in-urban-local-bodies-and-panchayati-raj-institutions/
3. https://www.drishtiias.com/daily-updates/daily-news-editorials/fiscal-devolution-in-panchayati-raj
4. https://india.mongabay.com/2023/03/state-finance-commissions-in-poor-shape/
5. https://www.imf.org/external/pubs/ft/seminar/2000/fiscal/rao.pdf
6. https://fincomindia.nic.in/asset/doc/commission-reports/15th-FC/reports/studies/Devolution%20of%20Union%20FC%20grants%20to%20Panchayats.pdf
7. https://prsindia.org/policy/report-summaries/report-15th-finance-commission-2021-26
8. https://www.pib.gov.in/PressReleaseIframePage.aspx?PRID=2104325
9. https://www.pib.gov.in/PressReleasePage.aspx?PRID=1750188