Devolution of funds

1. Meaning and significance of fiscal devolution

Fiscal devolution is the transfer of revenue-raising powers, financial resources and expenditure discretion to elected local governments. It is the financial component of democratic decentralisation, alongside the transfer of functions and functionaries. A Panchayat responsible for drinking water cannot perform effectively if it lacks money for repairs or control over the personnel maintaining the system. Financial resources must therefore correspond to expenditure responsibilities.

Devolution is more than routing expenditure through a local body. When a Panchayat merely implements a centrally or state-designed scheme with tightly prescribed activities, it acts largely as an implementing agency. Genuine devolution provides a predictable resource envelope and reasonable freedom to choose priorities within legal responsibilities. Tied grants can still support decentralisation, but they offer less discretion than untied resources.

Two fiscal gaps explain the need for transfers. Vertical imbalance arises when higher governments control productive tax bases while local governments bear substantial service-delivery responsibilities. Horizontal imbalance reflects differences among local bodies in taxable wealth, population, geography and service costs. Well-designed transfers address both without eliminating incentives to mobilise local revenue.

• Funds, functions and functionaries are complementary, not interchangeable.
• Fiscal autonomy includes revenue authority, spending discretion and reliable access to resources.
• Devolution should be assessed through actual releases and expenditure powers, not merely budget announcements.

2. Constitutional architecture

The Seventy-third and Seventy-fourth Constitutional Amendments, 1992, introduced Parts IX and IXA respectively. Articles 243G and 243W enable state legislatures to endow Panchayats and Municipalities with powers needed to function as institutions of self-government. The accompanying Eleventh and Twelfth Schedules identify potential functional domains. They neither create an automatic revenue entitlement nor require identical fiscal arrangements across states.

Under Articles 243H and 243X, a state legislature may authorise local bodies to levy, collect and appropriate specified taxes, duties, tolls and fees. It may also assign state-levied revenues, provide grants-in-aid from the state's Consolidated Fund and establish funds for receiving and spending local money. Thus, local taxation authority is mediated by state law rather than a separate constitutional tax list for local governments.

Article 243I requires the Governor to constitute a State Finance Commission within one year of the Seventy-third Amendment's commencement and thereafter every fifth year. Article 243Y extends its review to Municipalities. Articles 243J and 243Z permit state legislation governing local accounts and audit. Article 280 links the Union Finance Commission to local finances through recommendations for augmenting state Consolidated Funds.

• The State Finance Commission is constituted by the Governor; the Union Finance Commission is constituted by the President.
• The Constitution does not prescribe a uniform percentage of state revenue for local bodies.
• There is no general constitutional borrowing entitlement for local bodies; borrowing powers and approvals depend on applicable laws.

3. Sources of local-government finance

Own-source revenue includes taxes and non-tax receipts authorised by state law. Property tax is especially important for Municipalities, while Panchayats may receive house taxes, market fees or other local levies depending on the state. Non-tax sources include user charges, licence fees, rents and income from local assets. Improving collections requires updated assessment registers, transparent valuation, accessible payment systems and credible grievance redress.

Assigned and shared revenues originate in state taxation but are transferred to local bodies under specified arrangements. These differ from grants-in-aid, which are transfers from higher governments and may be general-purpose or conditional. Untied grants permit broader local prioritisation, subject to applicable restrictions. Tied grants reserve resources for specified services, such as sanitation or drinking water; they are not freely interchangeable with general revenue.

Scheme funds, including resources for rural employment or urban infrastructure, can be financially substantial without creating equivalent local discretion. Borrowing and municipal bonds provide capital finance for eligible urban bodies, but they are repayable liabilities rather than revenue devolution. Public-private partnerships likewise do not replace the need for sound public finances. A diversified resource base reduces dependence, but poorer jurisdictions still require equalising transfers.

• Own-source revenue is not synonymous with total receipts.
• A grant is not a loan; a municipal bond creates debt-servicing obligations.
• Financial autonomy must be balanced with affordability and protection of vulnerable households.

4. Finance Commissions and transfer design

The State Finance Commission recommends principles governing distribution between the state and local bodies of the net proceeds of specified state taxes, allocation among local bodies, assignment of revenues and grants-in-aid. It also recommends measures to improve their financial position. The Governor must lay its recommendations, together with an explanatory memorandum on action taken, before the state legislature. Recommendations are not automatically self-executing fiscal entitlements.

Under Articles 280(3)(bb) and 280(3)(c), the Union Finance Commission recommends measures to augment state Consolidated Funds to supplement Panchayat and Municipal resources, on the basis of State Finance Commission recommendations. This is distinct from constitutional tax devolution to states. Local bodies do not receive a separate, constitutionally fixed share of the Union divisible pool.

For 2021–26, the Fifteenth Finance Commission recommended local-government grants of ₹4,36,361 crore. This comprised ₹2,36,805 crore for rural local bodies, ₹1,21,055 crore for urban local bodies, ₹70,051 crore in health grants through local governments, and ₹8,450 crore for new cities and shared municipal services. For rural local bodies and non-million-plus cities, 60 per cent of the relevant grants were tied to sanitation and drinking-water-related purposes and 40 per cent were untied. These proportions should not be applied indiscriminately to every grant category.

• Population, area, fiscal capacity and service deficits can inform formula-based distribution.
• Performance conditions should encourage better governance without systematically excluding low-capacity bodies.
• Finance Commission award periods and category-specific grant rules matter in factual questions.

5. Implementation gaps and reform priorities

Major obstacles include delayed constitution of State Finance Commissions, weak fiscal databases, selective acceptance of recommendations and delayed releases. Local bodies may also face unfunded mandates: responsibilities are assigned without adequate revenue or staff. Excessive dependence on narrowly tied schemes can crowd out maintenance, while overlapping development authorities and departmental agencies weaken local control over urban services.

The Second Administrative Reforms Commission's report on local governance emphasised substantive decentralisation and stronger local financial arrangements. Reform priorities include timely State Finance Commissions, transparent transfer formulas, predictable release calendars and clear activity mapping across tiers. Property mapping, realistic user charges and professional accounting can improve revenue and expenditure management, but technology alone cannot substitute for lawful authority or political accountability.

Accountability should accompany autonomy through publicly accessible budgets, annual accounts, audits, Gram Sabha scrutiny and service-level reporting. Article 243ZD provides for District Planning Committees to consolidate Panchayat and Municipal plans, helping connect local priorities with district development planning. The ultimate test of financial devolution is not simply how much money is transferred, but whether elected local institutions can deliver equitable, reliable services.

• Link transfers to clearly assigned responsibilities and realistic service costs.
• Track budgeted, released, received and spent amounts separately.
• Combine revenue effort with equalisation so that poorer localities are not penalised for weak tax bases.

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