The paper analyses the state influence on the formation of the municipalities’ budgets in Latvia. According the legislation municipalities function on their own account in the frames of prescribed competences. The number of municipalities decreased from 522 till 118 in the result of the administrative and territorial reform in the 1st of July 2009. Two level municipalities system was transformed into one level system. The main aim of this reform was to establish stronger municipalities with greater possibilities to develop and provide qualitative services to the inhabitants. Despite the fact that municipalities form budgets on their own account, the governments’ solutions influence this process, especially the revenues. The municipalities’ budgets revenues consist from taxes (54%) and state subsidies (36%). The state fiscal policy concerning the personal income tax is especially important for municipalities, because this tax is main revenue source for them. Taking into account a downswing in economy the tax collection basis will be expand in 2010. The second very important instrument for regulation of municipalities’ finances is limits’ of loans and guarantees determination. These limits were turned down since 2009 except EU projects co financing. The total situation in the municipalities’ budgets in Latvia changed for the worse in 2008 because the finance discipline was disregarded very often – current expenses were covered from savings and not from current revenues. As a result total municipalities’ deficit came to 0.6% of GDP. It is obvious that municipalities’ expenditures policy differed from the government policy. The main conclusion is that government is unable to mobilize municipalities in a downswing situation by using the above mentioned fiscal instruments. Municipalities in the conditions of limited amount of resources create a risk of the state budgets’ deficit.