The Sixteenth Finance Commission has recommended a substantial Rs. 7.91 lakh crore in grants for duly constituted rural and urban local bodies over 2026-27 to 2030-31. In this context, Saurabh Bandyopadhyay contends that the Union Finance Commission ought to ensure continuity and predictability of local financing while using the same financial leverage to build stronger State Finance Commissions.
India has spent more than three decades building the constitutional architecture of local government. The 73rd and 74th Constitutional Amendments gave Panchayats and municipalities constitutional recognition and envisaged them as institutions of self-government. Yet India’s decentralisation remains unfinished. The problem is not simply that local governments do not receive enough money. It is that the institutional chain through which resources, responsibilities, and accountability are devolved remains weak. The Sixteenth Finance Commission’s treatment of State Finance Commissions (SFCs) brings this problem into sharp focus.
The chain of fiscal federalism – and its fragile middle
The Commission acknowledges the crucial constitutional role of SFCs in determining the resources available to rural and urban local bodies. At the same time, it points out that successive Finance Commissions have found it difficult to use SFC recommendations because many states do not constitute these commissions on time and the reports that are available vary considerably in their methodology, coverage, and quality. This leads to an uncomfortable but important question: if SFCs are too weak to inform fiscal devolution, should India bypass them – or make them work? The answer should be the latter.
India’s fiscal federalism is usually discussed as a relationship between the Union and the states. Decentralisation, however, introduces a third tier of government, making the institutional architecture considerably more complex. The Union Finance Commission has a constitutional role in recommending measures for local bodies, while SFCs are expected to examine the finances of Panchayats and municipalities within individual states. In principle, this creates a powerful chain of fiscal federalism – from the Union to the state, from the State to local governments, and ultimately from local governments to citizens. When the SFC is weak, however, the middle of this chain becomes fragile.
This matters because the Sixteenth Finance Commission itself recognises that the primary responsibility for providing the funds and functionaries required to perform functions devolved to local governments rests with state governments. Finance Commission grants are supplementary. The Commission has recommended a substantial Rs. 7.91 lakh crore in grants for duly constituted rural and urban local bodies over 2026-27 to 2030-31. But even such a large transfer from the Union cannot substitute for a functioning system of state-level fiscal devolution. The real question, therefore, is not simply how much money the Union gives local governments, but how systematically states transfer resources and responsibilities to them. That is precisely where SFCs should matter.
States are incentivised to constitute and maintain State Finance Commissions
The Sixteenth Finance Commission’s response to the weakness of SFCs is particularly interesting. On the one hand, it recommends removing from Articles 280(3) (bb) and 280(3)(c) the constitutional requirement that the Union Finance Commission make its recommendations on local bodies “on the basis of” recommendations made by SFCs. The Commission argues that the practical difficulties in obtaining meaningful and comparable SFC recommendations are unlikely to disappear in the foreseeable future. It has instead suggested that NITI Aayog study the functioning of SFCs across states and document good practices.
On the other hand, the Commission has strengthened the incentive for states to constitute SFCs. It recommends that every state comply with the constitutional requirement to constitute an SFC after the expiry of five years from the constitution of the previous one and that the Action Taken Report on the SFC’s recommendations be placed before the state legislature within six months. Compliance with these requirements is made a condition for accessing local-body grants from 2026-27. In other words, the Commission is simultaneously reducing the formal dependence of Union-level devolution on SFC recommendations while strengthening the incentive for states to maintain functioning SFCs. What appears at first to be a paradox may actually point towards a sensible transition.
The Union Finance Commission need not wait for imperfect SFC reports before making its own recommendations. But that should not mean that the SFC is gradually rendered irrelevant. Instead, the financial leverage of the Union should be used to ensure that SFCs become credible institutions of state-level fiscal federalism. The danger is that SFC conditionality could otherwise become merely another compliance exercise. A state may constitute an SFC, produce a report and place an Action Taken Report before the legislature, while the underlying weaknesses – inadequate data, limited analytical capacity, poor local-government accounts, and weak follow-through – remain unresolved.
The next generation of reforms of State Finance Commissions
The experience of the Sixteenth Finance Commission itself illustrates the problem. Although the availability of local-body financial data has improved considerably, the Commission notes that reliability and consistency across different platforms remain serious concerns. The next generation of SFC reforms should therefore focus not merely on whether an SFC exists, but on whether it works. A credible SFC requires reliable and standardised local-government accounts, a common methodology for assessing expenditure needs, credible estimates of own-source revenue, transparent criteria for state-to-local transfers, adequate professional and technical capacity, and a mechanism for tracking whether the transfers recommended by the SFC are actually made.
This is particularly important because India’s local governments remain heavily dependent on grants from higher levels of government. The Sixteenth Finance Commission notes that Panchayats in many states depend on grants for more than 90% of their revenues, while own-source revenue covers only about 6-8% of their expenditure. Such dependence weakens both autonomy and accountability. A local government that has little control over its revenues and relies overwhelmingly on grants has limited fiscal space to respond to local priorities and, equally importantly, limited accountability to citizens for raising and spending public resources.
The Commission is therefore right to place greater emphasis on own-source revenue mobilisation. It links part of the local-body performance grants to improvements in own-source revenue. For Gram Panchayats, for example, eligibility for the rural performance component from 2028-29 is linked to a minimum increase in own-source revenue, subject to a minimum amount per household. This is a welcome attempt to connect fiscal responsibility with fiscal transfers. But there is also a limit to what local revenue mobilisation can achieve. A poor rural Panchayat cannot be expected to finance the same level of public services from its own revenue as a prosperous urban municipality. Fiscal autonomy cannot mean fiscal self-sufficiency.
That is precisely why a strong SFC is necessary. It should help answer three basic questions: what functions should a local government perform, what can it reasonably raise on its own, and what level of state transfer is required to bridge the gap? The SFC should therefore not simply become another committee that periodically produces a report. It should become the institutional mechanism through which the state negotiates the fiscal compact with its local governments.
This also requires greater transparency in state finances. The Sixteenth Finance Commission recommends that states separately report in their budgets all transfers to local bodies, including Finance Commission grants, SFC grants, Centrally Sponsored Scheme transfers and other state government transfers. This is more than an accounting reform. If citizens and local governments cannot clearly see how much the state is transferring, through which channels, and for which purposes, it becomes difficult to assess whether decentralisation is actually taking place.
The next step should therefore be to make the SFC report a kind of public fiscal contract between the state and its local governments. Its recommendations should clearly identify the functions assigned to each tier, the expenditure requirements associated with those functions, the revenue that local governments can reasonably mobilise, and the transfers that the state is expected to provide. The Action Taken Report should then show, transparently, what the state accepted, what it rejected, and what it actually implemented.
This would shift the SFC from a constitutional formality to an institution of fiscal federalism. It would also address a fundamental weakness in India’s decentralisation model: the tendency to treat local governments primarily as recipients of schemes and grants rather than as governments with their own responsibilities, revenue bases, and accountability to citizens.
A parallel-track strategy
The objective, therefore, should not be to make the Union Finance Commission permanently substitute for weak SFCs. Nor should India wait indefinitely for every SFC to become perfect before transferring resources to local governments. A better approach is a parallel-track strategy. The Union Finance Commission should continue to provide predictable, formula-based grants to local governments, while those transfers should create stronger incentives for states to institutionalise credible SFCs. Over time, SFCs should become the principal institutions for answering a fundamental question within each state: what does decentralisation actually cost, who should finance it, and how should those resources be shared among local governments?
The Sixteenth Finance Commission has already put substantial resources behind local government. The larger opportunity is to ensure that these resources become the foundation for genuine self-government rather than another layer of intergovernmental transfers. India does not need to choose between bypassing weak SFCs and relying on them blindly. It should use the Union Finance Commission to ensure continuity and predictability of local financing while using that same financial leverage to build stronger SFCs.
The real test of the Sixteenth Finance Commission, therefore, will not simply be whether local governments receive more money between 2026 and 2031. It will be whether, by 2031, SFCs have become strong enough that India no longer has to ask whether they can be trusted with the job.
That is the real unfinished business of fiscal decentralisation in India: not merely transferring more money to local governments but building the institutions that allow them to govern with money, responsibility, and accountability.
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