This paper examines the impact of restricted and unrestricted fiscal grants on tax effort of Panchayats using nationally-representative panel data on finances. We propose three pathways through which these impacts accrue: wages, profits, and incentives. In order to deal with the simultaneities of grants received and taxation, we estimate a system of equations simultaneously, where the first stage equations predict the grants. The results show that a wage impact on taxation exists, but is very small and, the productivity impact of grants on taxes is negligible. This means that incentives effects associated with the specifics of the intergovernmental fiscal system in the states is the main determinant of village taxation. Several policy conclusions are advanced.