Final answer:
In 1996, Kerala dedicated 40% of its state budget to the panchayat system, showing a strong commitment to local governance and decentralized power.
Step-by-step explanation:
In 1996, the Indian state that allocated 40% of its entire state budget to panchayats was Kerala. This move underscored the state's commitment to decentralization and empowerment of local governance. Panchayats are the Indian system of local government in rural areas, which play a critical role in the grass-roots level administration and development. Kerala's initiative served as an important development in the devolution of power to panchayats, supporting more localized decision-making and governance.