The Financial Sphere: Navigating State and Local Government Interactions

Money is the lifeblood of any government – and for rural local bodies in India, the pipes that carry this lifeblood run directly through the state government. While panchayats are celebrated as the third tier of our democracy, their financial independence is far more limited than their political status suggests. Every rupee collected, borrowed, budgeted, or spent at the village level passes through a web of state-level rules, approvals, and scrutiny. Understanding this financial sphere is essential to understanding how rural self-government really works on the ground.

The constitutional architecture of financial relations 🔗

The financial relationship between state governments and rural local bodies is rooted in the 73rd Constitutional Amendment Act of 1992, which added Part IX to the Constitution. While this amendment gave panchayats constitutional status, it deliberately left most financial powers to state legislatures. Giving due consideration to India’s federal structure, most financial powers and authorities to be endowed on panchayats were left to the discretion of concerned state legislatures.

This means that although the Constitution provides the scaffolding, the real walls, doors, and windows of panchayat finance are built by each state through its own Panchayati Raj Act. The result is a patchwork across the country – Kerala operates very differently from Haryana, and Karnataka’s system is not the same as Bihar’s.

Key constitutional provisions 🔗

Three articles do most of the heavy lifting here. Article 243H empowers the state legislature to authorise a panchayat to levy, collect, and appropriate certain taxes, duties, tolls, and fees; to assign to panchayats the revenues from certain state-level taxes; and to provide for grants-in-aid from the Consolidated Fund of the State. Article 243-I mandates a State Finance Commission (SFC) every five years to review the financial position of panchayats. Article 243J allows the state legislature to make provisions for the maintenance of accounts and their audit.

Control over funds: who holds the purse strings? 🔗

Rural local bodies receive funds from four main streams: Central Finance Commission grants, State Finance Commission devolutions, Centrally Sponsored Schemes, and their own source revenue (OSR). The state government acts as both a conduit and a gatekeeper for the first three.

The scale of state control becomes clear when we look at the numbers. According to a Reserve Bank of India study, panchayats earn only about 1% of their revenue through their own taxes, while roughly 80% comes from Central government grants and 15% from State government grants. This extreme dependence gives state governments enormous practical leverage, even where constitutional autonomy exists on paper.

There is also a structural bottleneck. Central Finance Commission grants do not go directly to panchayats – they flow through the state treasury first. As the India Development Review has observed, when statutory transfers to panchayats are made after states receive the money, local governments become financially dependent on the states and often remain underfunded. Delays in onward transmission can paralyse projects at the village level for months.

Taxation: a narrow and reluctant domain 🔗

Panchayats can levy only those taxes that the state legislature explicitly permits. Most taxation powers are concentrated at the Village Panchayat level, covering property tax, profession tax, vehicle tax, fairs and markets, water charges, and a few others. Intermediate and District Panchayats have an even thinner tax domain, limited largely to ferry services, markets, water and conservancy services, and cesses on stamp duty.

Two problems compound the narrow tax base. First, rates and collection procedures are usually prescribed by the state – panchayats cannot freely design their fiscal policy. Second, elected representatives are often reluctant to collect revenue from their own neighbours, fearing backlash at the next election. The RBI has noted that PRIs have limited powers to impose cesses and taxes, and are generally reluctant to raise necessary funds for fear of losing popularity with the masses.

The consequence is fiscal fragility. In the fiscal year 2022-23, panchayats collectively generated only about Rs 737 crore through their own tax revenue out of a total revenue of roughly Rs 35,354 crore. On average, each panchayat earned just Rs 21,000 from its own taxes – a figure that barely covers stationery and basic operating costs.

Borrowing: a power rarely exercised 🔗

Borrowing by panchayats is another area where the state holds a tight rein. Rural local bodies cannot raise loans or issue any form of debt without the prior approval of the state government. State Panchayati Raj Acts typically specify the purposes for which borrowing is allowed (usually limited to capital works), set ceilings on borrowing limits, and often require the state government to guarantee or countersign loans from financial institutions.

In practice, borrowing is a minor part of panchayat finance. Most village-level bodies lack the creditworthiness, the audited accounts, and the technical capacity to access institutional finance. State governments, for their part, are cautious about guaranteeing loans that could become liabilities on the state exchequer. This leaves grants and devolutions as the dominant source of funds – reinforcing dependency.

Grants-in-aid: the single most powerful lever 🔗

Grants-in-aid are where state oversight bites hardest. These transfers come in several forms – general-purpose grants, scheme-specific grants, matching grants, and performance-based grants – and each category carries its own conditions.

The State Finance Commission’s role 🔗

Under Article 243-I, every state is required to constitute a State Finance Commission every five years to recommend the distribution of taxes between the state and panchayats, the determination of taxes that may be assigned to panchayats, the grants-in-aid to panchayats from the Consolidated Fund of the State, and measures needed to improve the financial position of panchayats.

The SFC’s recommendations are advisory – the state government is not bound to accept them in full. A parliamentary standing committee noted in 2025 that only 25 out of 28 states had constituted State Finance Commissions, and that from 2024-25 onwards, setting up an SFC has become a mandatory condition for accessing certain central grants. Many SFC reports are tabled years late, and their recommendations are often diluted by the time they are implemented.

Tied versus untied grants 🔗

The architecture of grants themselves creates dependency. Rural local bodies receive financial devolution from the Central Finance Commission in the form of tied grants (60%) and untied grants (40%), with tied grants usable only for sanitation and drinking water supply. If a panchayat has already achieved saturation in these categories through other schemes, the tied funds cannot be reallocated and may simply lapse. This tells you a lot about who really decides spending priorities.

Budgeting: prepared locally, approved from above 🔗

Every panchayat is required to prepare an annual budget – typically before the start of the financial year in March – showing estimated receipts and expenditures. But the budget is not a document that the panchayat alone can finalise.

At the Gram Panchayat level, the budget must be placed before the Gram Sabha for discussion. It is then forwarded to the Panchayat Samiti or the designated state authority (often the Block Development Officer or the District Panchayat Officer) for scrutiny. The approving authority can return the budget for modification, demand additional justification, or direct changes in allocation heads. For Zilla Parishads, the state government directly exercises budgetary oversight.

Most panchayats now follow the Model Panchayat Accounting System, with budget formats prescribed by the Comptroller and Auditor General of India. According to the CAG’s manual for PRI audit, the formats for preparation of budget and for keeping accounts by PRIs shall be as prescribed by the Comptroller and Auditor General. The eGramSwaraj platform now mandates online uploading of Gram Panchayat Development Plans as a precondition for receiving Central Finance Commission grants.

Accounting procedures: standardised and supervised 🔗

State governments prescribe detailed accounting rules that every panchayat must follow. The State Panchayati Acts and the Finance and Accounts Rules issued under them lay down the accounting procedures to be followed by PRIs, the forms of original and subsidiary books of accounts, and the formats of accounts statements and returns.

The shift from single-entry, cash-based accounting to double-entry, accrual-based accounting has been pushed through the Ministry of Panchayati Raj’s digital suite. The eGramSwaraj application now handles planning, budgeting, accounting, monitoring, and asset management for most panchayats, creating a standardised digital trail that state and central authorities can monitor in real time.

Audit: the final layer of scrutiny 🔗

Audit is the mechanism through which the state ensures that public funds entrusted to panchayats are used lawfully and productively. The audit regime typically operates at three levels.

Internal and local fund audit 🔗

The primary audit of panchayat accounts is usually conducted by the state’s Directorate of Local Fund Audit or an equivalent department. This audit checks arithmetic accuracy, compliance with rules, sanction of expenditure, and proper maintenance of records. The audit reports are submitted to the state government and often discussed in the Gram Sabha.

CAG audit 🔗

The Comptroller and Auditor General provides technical guidance and supervision (TGS) over the primary audit in most states. In some states, the CAG also conducts direct audits of higher-tier panchayats. As one study notes, the Karnataka Panchayati Raj Act, 1993 provides for the audit of Taluk Panchayat Funds and Zila Panchayat Funds by the CAG, while the Controller of State Accounts may authorise any officer to audit Gram Panchayat funds.

Conditional audit compliance 🔗

Audit has become a gateway condition for future funding. The Fifteenth Finance Commission made the availability of online annual accounts and audited accounts an entry-level condition for any grant to local bodies. Panchayats that fail to publish audited accounts simply do not receive their share of Union grants – a powerful financial incentive that has improved compliance dramatically in recent years.

The politics of financial control 🔗

Why do states maintain such tight financial control over panchayats? The reasons are partly administrative and partly political. Administratively, states worry about fiscal discipline, misappropriation, and the technical capacity of elected village representatives. Politically, devolving real financial power to panchayats means giving up patronage, contract allocation, and scheme implementation – levers that state-level leaders are reluctant to surrender.

The Ministry of Panchayati Raj’s own Panchayat Devolution Index 2024 ranked states on how well they were devolving powers and resources to panchayats, with Karnataka leading in the finances sub-index, followed by Kerala, Tamil Nadu, and Rajasthan. The wide variation across states – and the poor performance of many – reflects the political economy of decentralisation more than any constitutional limitation.

The road ahead: reforms in motion 🔗

Several reforms are underway to recalibrate this relationship. The RBI report on PRI finances has called for greater decentralisation, enhanced financial autonomy, transparent budgeting, fiscal discipline, community involvement in prioritisation, and rigorous monitoring and evaluation. The 2025 Standing Committee report has recommended a time-bound roadmap for devolution, reallocation of tied grants, and an annual State of Devolution Report.

Technology is quietly changing the dynamic too. AuditOnline, PRIA Soft, PlanPlus, and eGramSwaraj have made financial data more visible to citizens and auditors alike. Real-time dashboards mean that delays and irregularities are harder to hide. Over time, this transparency may shift the balance of power in ways that formal legal changes have not yet achieved.

For now, the financial sphere of state-local interaction remains a study in controlled autonomy. Panchayats have a constitutional identity but a fiscally dependent existence. They plan at the grassroots but seek approvals from above. They spend public money but answer to state auditors for every paisa. Whether this balance tilts further toward genuine devolution in the coming decade will shape the future of rural democracy in India.

What do you think? If panchayats generate only about 1% of their revenue from their own taxes, can they truly be called institutions of self-government – or are they better understood as implementing arms of the state? And should the Consolidated Fund of India be amended to transfer Finance Commission grants directly to panchayats, bypassing the state treasury altogether?

References

1. https://www.mea.gov.in/Images/pdf1/Part9.pdf
2. https://en.wikipedia.org/wiki/Local_government_in_India
3. https://www.drishtiias.com/daily-updates/daily-news-analysis/finances-of-panchayati-raj-institutions
4. https://idronline.org/article/advocacy-government/the-state-of-indias-panchayati-raj-system/
5. https://inclusiveias.com/upsc-polity-panchayati-raj-system-india/
6. https://prsindia.org/policy/report-summaries/devolution-of-funds-under-panchayati-raj-system
7. https://cag.gov.in/uploads/media/PRI-Manual-20201127173825.pdf
8. https://cpgfm.icai.org/wp-content/uploads/2025/05/Publication-on-Accounting-Auditing-Compliance-of-Panchayati-Raj-Institutions-PRIs.pdf
9. https://www.cbgaindia.org/wp-content/uploads/2016/03/Decentralisation-of-Finances-A-Study-of-Panchayat-Finances-in-India.pdf