The objective of this study is to review panchayat finances, identify issues and make recommendations to improve the fiscal decentralization system. Using Kamataka and Kerala as case studies, this report describes the context for rural decentralization in India, summarizes the current fiscal situation of district, block and village panchayats, identifies the main problems arising from the current practice, and outlines a set of reform options that might better satisfy the objectives of the central and state governments. Kamataka and Kerala were examined because these two states are generally thought to be more advanced than others in implementing rural fiscal decentralization and are therefore relevant for drawing lessons for the rest of India. There is a hierarchical arrangement of center-state-local governance. The 73rd Amendment to the Constitution made India one of the most politically decentralized countries in the developing world. By the Constitution and in practice, local government has an urban and a rural stream. Rural local governments are divided into three levels: district (zilla), block (taluk), and village (gram) panchayats. The design and implementation of the decentralization program are a state government responsibility. However implementation of key aspects of the program is lagging. Districts and blocks have no taxing powers and little expenditure autonomy. Both in Karnataka and Kerala, they more or less function as spending agents of higher-level governments. Gram panchayats are closest to the people, have some independent taxing power, and some discretion in expenditure decisions. Hence they are the primary subjects of this study.