UPI and the cost of policy reversal

The proposed amendment highlights the complex economics of two-sided markets (platforms connecting two distinct user groups, like consumers and merchants on UPI). Taxing such markets is inherently difficult due to tax incidence (who ultimately bears the economic burden of the tax). While the government intends the MDR (the fee a merchant pays to a bank for processing a transaction) to fall on merchants, the actual burden may shift. Due to intense competition, merchants might resist absorbing the cost, and intermediaries like banks or National Payments Corporation of India (NPCI) ecosystem players may have to absorb it to retain transaction volume. If intermediaries absorb the cost, it could reduce their capital for investing in infrastructure, security, and innovation, potentially leading to a degradation in service quality. Furthermore, comparing UPI to credit cards, which attract 18% Goods and Services Tax (GST), reveals a broader policy pattern that treats electronic payments not just as utilities, but as taxable services, contrasting with international norms where consumer credit interest is generally a private financial cost.

The shift in policy raises critical governance questions about consistency and the long-term impacts of policy reversals. The zero-MDR regime was a deliberate strategy to achieve financial inclusion by pulling informal transactions into a formal, digital trail. This formalization provides data for banks to build credit profiles, fostering deeper financial integration. Introducing a fee on large transactions, even if ostensibly targeted at only 5% of transaction volume (but 65% of transaction value), fundamentally alters the economic incentives that drove UPI's massive adoption. The author argues that this reversal risks undermining the decade-long policy goal of moving away from cash, particularly the objectives established post-demonetization. The amendment to the Payment and Settlement Systems Act, 2007 creates legal architecture for taxation that persists even if the current MDR proposal is shelved, giving the government broad discretionary power over the payments ecosystem in the future.

The potential social impact of this policy hinges on its effect on financial behavior. The success of UPI relies heavily on network effects (where the value of a service increases as more people use it). A zero-cost structure encourages widespread adoption across diverse socioeconomic segments, including small merchants and rural users. While the proposed MDR targets larger transactions, any perceived cost could reintroduce friction into the digital payment process. If merchants begin to reject UPI for higher-value transactions or pass the cost to consumers, it could reverse the behavioral shift towards digital payments, pushing users back towards cash. This potential reversal contradicts the broader social objective of bringing the unbanked and underbanked into the formal financial system, potentially stalling progress in financial literacy and inclusion driven by the widespread accessibility of free digital payments.