Will UPI based tax demands hurt financial inclusion?

In parts of Karnataka – home to India’s Silicon Valley – the familiar cha-ching of UPI payments is slowly fading. It’s being replaced by ruffling of cash exchanging hands. Not because customers have suddenly developed a preference for physical currency, but because merchants are second-guessing the very technology that helped their businesses grow. 

Prasanna CS discovered this the hard way. His small stall at Mysuru's bus terminus had thrived on digital payments. UPI made everything smoother - no haggling over change, instant settlement, satisfied customers. Business was good. Then the envelope arrived. 

The Karnataka Commercial Tax Department wanted explanations for Rs 30 lakh worth of UPI transactions flowing through his business. Prasanna, who had never seen that kind of profit margin, panicked. His immediate response was to eliminate what he perceived as the source of trouble: he stopped accepting digital payments entirely. 

"I have stopped the subscription for the UPI accepting sound devices. Ever since I stopped using UPI, my business has dropped. I might have to shut shop and return to my hometown," Prasanna told reporters. 

Prasanna isn't an isolated case. Across Karnataka, thousands of small traders are making similar decisions. The state's commercial tax department sent notices to 14,000 businesses, using UPI transaction data to identify those who should be registered under GST but weren't. The logic was solid: businesses with annual turnover above Rs 40 lakh must register. Digital transactions left a clear trail for the first time. 

Yet this enforcement approach has triggered an unexpected response. Instead of rushing to comply with tax regulations, many merchants are simply opting out of the digital payments' ecosystem altogether. 

What makes this development particularly intriguing is its timing and scale. Four more states - Andhra Pradesh, Uttar Pradesh, Tamil Nadu, and Gujarat - have followed Karnataka's lead, requesting similar UPI transaction data from payment platforms. The model is spreading, and so is merchant resistance. 

But here's what makes this story more than just another regulatory friction: the retreat from digital payments is quietly dismantling something much bigger than tax compliance. It's affecting the foundation of modern small business lending in India. 

The second-order effects of digital clampdowns 

For the past decade, a transformation has been underway in how credit reaches India's smallest businesses. Banks and NBFCs, traditionally hesitant to lend without formal documentation, discovered that digital payment patterns could reveal creditworthiness more accurately than balance sheets. A roadside vendor's consistent UPI receipts indicated a reliable cash flow. A small shop's transaction frequency suggested customer loyalty. Payment timing revealed business cycles. 

This wasn't just convenient data collection. It was the birth of alternative credit scoring, opening formal finance to millions of businesses that had operated in the shadows of the cash economy. Every UPI payment created a digital breadcrumb, every transaction built a credit history, every settled amount contributed to an assessable financial profile. 

Now, those breadcrumbs are disappearing. 

When Jayaram Poojari, a Bengaluru shopkeeper, received his GST notice demanding Rs 6 lakh based on his UPI transactions, he faced an impossible equation. His margins on items like cigarettes are razor thin. He doesn't have Rs 6 lakh sitting in reserve, but his payment volumes suggested otherwise to tax authorities. The math simply didn't work in his favor. 

"I am still accepting UPI, but the government should explain why only small vendors are being targeted," Poojari said, capturing the frustration many merchants feel. 

The core issue lies in how enforcement agencies interpret transaction data. UPI receipts don't distinguish between GST-taxable goods and exempt items. A vegetable vendor processing Rs 50 lakh annually might be handling entirely tax-exempt products. A grocery store's transactions span multiple tax categories. A tea stall's receipts mix items with different GST treatments. 

Tax authorities see transaction volumes. Merchants see potential persecution for successful businesses. 

The implications extend far beyond individual merchant decisions. India's MSME sector employs over 240 million people and contributes nearly 30% to GDP. Yet formal credit access has historically been limited by documentation requirements and collateral demands that most small businesses cannot meet. 

The damage to digital credit  

Digital payment adoption was changing this dynamic. Lenders developed sophisticated models to assess credit risk using transaction patterns, frequency analysis, and behavioral data.  

Early warning systems could identify stressed accounts through payment irregularities. Fraud detection mechanisms analyzed spending patterns. Credit enhancement tools used digital footprints to reduce information asymmetry between lenders and borrowers. 

When merchants abandon digital payments, this entire infrastructure loses its primary data source. Transaction histories vanish from lender databases. Cash flow patterns become invisible. Credit assessment returns to traditional methods that often exclude businesses without conventional documentation. 

The scale of potential disruption is significant. UPI processes over 18 billion transactions monthly, worth over Rs 24 lakh crore. Merchant payments represent 63% of this volume. This infrastructure took years to build and represents massive investments in technology, behavior change, and market development. 

Karnataka's Commercial Tax Commissioner Vipul Bansal has attempted to ease merchant concerns, clarifying that notices aren't final demands and that businesses can submit detailed breakdowns to recalculate obligations excluding exempt items. But confidence, once shaken, proves difficult to restore. Reports indicate merchant acquirers are already receiving subscription cancellation requests. 

The bigger question this situation raises is whether immediate compliance objectives justify potential setbacks to financial inclusion progress. The digital payment ecosystem that enabled new forms of credit assessment took years to mature. Its reversal could happen much faster. 

This creates a particularly troubling cycle. MSMEs with limited credit access struggle to grow, invest, or weather economic uncertainties. When they retreat to cash transactions to avoid regulatory attention, they become even more excluded from formal financial services. The very businesses that India's economic policy aims to support find themselves pushed further to the margins. 

The solution requires recognizing that tools designed for large, formal businesses don't automatically translate to small trader realities. Enforcement mechanisms need to account for the complexity of mixed-goods businesses and the difference between transaction volume and taxable turnover. 

More fundamentally, it requires coordinated thinking between tax policy and financial inclusion objectives. When one department's compliance drive undermines another's inclusion goals, the net effect can be economically counterproductive. 

The stakes go beyond immediate tax collection. They touch the core question of how India's economy includes or excludes its smallest participants. As merchant UPI devices go silent across multiple states, we're witnessing a test of whether regulatory efficiency can coexist with inclusive growth. 

The outcome will determine not just how Indians conduct their daily transactions, but who gets access to the credit, investment, and opportunities that enable business growth. Time is to tell whether a tea vendor keeps his UPI QR code active or switches it off forever. 

Until next time. 

Cheers, 

Rajat Deshpande