From QR Codes to Tax Notices: Why Digital Inclusion Fails to Formalize India’s Informal Sector
Aanya Bansal | Sam Kunin
India’s experiment with digital payments has achieved what few emerging economies have managed: the informal sector now transacts through a state-backed platform at national scale. Yet this achievement has exposed a deeper structural problem. The Unified Payments Interface (UPI) generates unprecedented visibility, but the tax system that sits behind it still treats small businesses as potential evaders rather than future taxpayers. When GST compliance costs are unpredictable and the economics of digital payments remain subsidized to the point of fragility, informal merchants interpret digitization as a risk, not a stepping-stone to formality.
The Unified Payments Interface (UPI) was introduced in 2016, and this protocol allows instant, bank-to-bank transfers, free to consumers and merchants. It has facilitated a boom in low-value digital payments and made cashless commerce accessible even to the most informal traders. The Reserve Bank of India (RBI) describes UPI as a “public good” and its adoption is so widespread that vendors who do not display UPI QR codes risk losing customers.
The spectacular rise of UPI rests on hard numbers. According to the Reserve Bank of India’s Report on Trend and Progress of Banking in India 2023–24, UPI now accounts for the majority of transaction volume in retail digital payments. What matters is not simply the scale, but the character of the transactions: the average value of retail digital payments has nearly halved since 2021, signaling deep penetration into everyday purchases. Digital payments are no longer the domain of affluent urban consumers or formal enterprises. They are a way to buy vegetables, pay auto-rickshaw drivers, and tip street vendors.
This success has inspired policymakers and commentators to imagine a digital shortcut to fiscal capacity. If every transaction leaves a trace, surely the state can use these trails to pull small enterprises into the Goods and Services Tax (GST) system. Yet the experience of informal businesses shows that visibility alone does not create compliance. Digitization reveals economic activity; it does not redesign the incentives around it.
A tax system built for firms, applied to households
Designed as a national value-added tax to replace a maze of state and local levies, GST was intended to simplify the environment for Indian commerce. It has done so for large firms, which have compliance departments and accountants. For informal traders, the same architecture functions as a labyrinth. Registration requires navigating turnover thresholds and multiple tax slabs. Ongoing participation demands regular filings, invoice matching, digital recordkeeping, and familiarity with penalties that can be imposed long after a transaction has occurred.
When tax authorities use digital trails as evidence of potential non-compliance, these burdens surface abruptly. Earlier this year, Bengaluru traders reported that GST officials were using UPI transaction histories to infer business turnover and demand registration or penalties. Some described the scrutiny as sudden and disproportionate, not because UPI was new to them, but because its digital exhaust had become a tool of enforcement. As coverage in the Economic Times documented, inspectors have issued GST notices to vendors based on four years’ worth of UPI transaction data, effectively treating aggregate QR‑code receipts as evidence of taxable turnover. For many vendors who accepted digital payments simply to satisfy customers, the message was clear: increased visibility leads to increased enforcement.
The backlash was immediate. As a result, Karnataka’s government launched a “Know GST” campaign to reassure small merchants and correct misconceptions. Reports in the Times of India described officials intending to host workshops and outreach events to create awareness and clarify regulations surrounding GST rules for small traders. These efforts are not cosmetic. They acknowledge a simple fact: informal traders are not refusing the digital rails; they are rejecting the fiscal cliff that comes packaged with them.
This incident underscores a broader institutional gap. India’s digital infrastructure has achieved frictionless transactional inclusion, while its tax infrastructure demands cognitive and administrative sophistication. A chai stall cannot be expected to behave like a corporate taxpayer simply because its customers pay through a QR code.
When visibility is not rewarded, it is avoided
In many economies, joining the tax net buys access to credit, legal safeguards and formal markets. In India’s informal sector, the equation is reversed. Compliance delivers few immediate benefits and introduces new risks. According to CFO.com Economic Times, traders fear penalties for misfilings, retrospective audits, and the possibility that a single error could escalate into months of bureaucratic engagement.
Faced with these costs, traders rationally adapt. Some keep UPI transactions below the GST threshold by turning away large digital purchases or reintroducing cash for bulk orders (Economic Times). Others split payments across accounts or use UPI only for consumer-facing sales while shifting supplier purchases offline (Economic Times). None of these behaviors reflect a rejection of the technology. They reflect a conscious management of visibility, driven not by fear of digitization but by fear of institutional consequences.
The state, meanwhile, treats UPI data as evidence without offering the administrative infrastructure required to convert visibility into voluntary compliance. Digital footprints can help with risk profiling, but if the first encounter with the tax system is punitive, adoption declines. Trust, once shaken, is difficult to rebuild.
The economics of “free” payments
Even if GST design were reformed tomorrow, India would still face a second structural problem: the sustainability of the digital payments ecosystem itself. UPI’s appeal rests partly on the government’s decision to impose a zero merchant discount rate (MDR), meaning merchants pay nothing to accept payments. The policy was intended to encourage adoption by keeping transaction costs minimal. It succeeded, but at a price.
Digital payment networks require ongoing investment in IT infrastructure, risk management, merchant services, and innovation. With zero MDR, payment service providers lack a stable transaction-based revenue model, leaving long-term viability uncertain. Recently, Business Standard quoted CareEdge Research that warns about the current zero-MDR framework as a challenge to the long-term sustainability of real-time digital payments in India. Further, BFSI Economic Times, shed light on industry-wide concerns echoed by the Payments Council of India, reinforcing this view, arguing that the absence of MDR and shrinking government incentives may force providers to scale back investments or reconsider support for low-margin, high-volume merchants. In other words: scale may continue to grow, but the institutional scaffolding that makes digital commerce reliable becomes thinner with each transaction.
Digital platforms priced at zero are politically popular but economically regressive. They undermine competition, reduce service quality, and curb the emergence of merchant-facing tools that could encourage formalization. For informal traders, the knock-on effect is real. UPI becomes a convenient front-end bolted onto a fragile back-end. Merchants interpret that fragility as another reason to keep digital usage limited, especially if the state appears eager to scrutinize every rupee that flows through it. In simple terms, India has built a world-class payments rail; it has yet to build a durable business model around it.
The future of India’s digital experiment
India’s state-led digital infrastructure is an extraordinary achievement. UPI has expanded financial inclusion and modernized commerce in ways that development economists will study for decades. Its limitations are not intrinsic to the technology but to the political economy around it. Policymakers treated UPI as a shortcut to formalization, bypassing the hard work of tax reform and administrative capacity.
The country now confronts the disquieting truth that digital innovation magnifies institutional flaws. India’s experiment holds lessons beyond its borders. Digital rails can connect millions to the financial system, but unless tax policy is humane and payment economics sustainable, those rails lead not to opportunity but to fear.
Aanya Bansal (BC ’28) is a writer for the Columbia Emerging Markets Review studying Economics. She has a keen interest in exploring how the micro-level choices of firms, consumers, and institutions shape macroeconomic outcomes in emerging markets, and is particularly interested in the spillover effects these dynamics generate. In her free time, she enjoys photographing the city, trying new cuisines, and binge-watching movies.
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