Can Tax Systems Cope with Cryptocurrencies?
Cryptocurrencies—Bitcoin being the leading and best-known example—excite strong reactions. Some see them as, at best, inherently worthless, ultimately doomed to be exposed as such; and, at worst (with spectacular collapses, such as that of FTX in November last year in mind), as a vehicle for the unscrupulous to poorly-informed investors. Warren Buffett once said that he would not give $25 for all the Bitcoin in the world. For others, however, cryptocurrencies are the harbinger of a brave new world in which people will be able to make financial transactions both more cheaply than now and without needing to place any trust in any financial institutions (also prone to their own scams and failures) or government.
But while it is unclear whether cryptocurrencies will wither away or become a central part of the financial ecosystem, tax systems need to be able to accommodate them—which they do not currently do well. That is hardly surprising: today’s tax rules were written before anyone had even dreamt of cryptocurrencies. In a recent Tokyo College Working Paper, co-authors Katherine Baer, Ruud de Mooij, Shafik Hebous, and I take a look at the tax challenges that cryptocurrencies create.
The most fundamental difficulty is that cryptocurrencies are “pseudo-anonymous” in the sense that transactions are conducted using “private addresses” (a bit like a PIN) that it is essentially impossible to link with particular individuals or firms unless they choose to divulge them. That does not create too much of a problem when people transact through centralized exchanges, since these can be made subject to standard “know your customer” rules that require the identification of the actual individuals or firms transacting, as well as stronger requirements that transactions be reported to the tax authorities. Many countries are in the process of putting such rules in place. Matters are much more complicated, however, if people transact directly with one another or through decentralized exchanges, which simply facilitate trading. Using centralized exchanges abroad can also keep domestic tax authorities ignorant of what is going on.
This does not mean that tax authorities are helpless. Another feature of cryptocurrencies is that they are remarkably transparent, in that all transactions are publicly available, which provides some clues on which investigative techniques can build. There are firms that specialize in this business of crypto analytics. And crypto users may eventually want to “cash out” for legal tender through more traditional financial institutions, creating potential for their identification at that point.
Nonetheless, this evidently leaves considerable scope not only for outright illegal activity through the darknet and other means—growing in scale, but a decreasing share of all cryptocurrency transactions—but for straightforward tax evasion. It is hard to assess the current scale of this; and looking forward, the extent of evasion may depend on whether the reaction to events such as the FTX collapse is to increase use of increasingly well-regulated centralized exchanges (likely to offer more security as their regulation improves) or instead to more reliance on decentralized exchanges (with a lesser need to trust anyone).
It is, however, possible to give a rough indication of the income tax revenue at stake, though the massive price volatility of cryptocurrencies implies a similar volatility of potential revenues. During the crypto boom in 2021, tax on the consequent capital gains might have raised 100-300 billion USD worldwide, which—to give a sense of scale—is around 5-10 percent of global revenue from the corporate income tax. Since the onset of crypto winter in late 2021 however, the story is one of large capital losses. In more normal times—and, admittedly, not much about crypto has been normal—the amount might be around only USD 10 billion, which, in the wider scheme of things, is not a huge amount.
That said, beyond revenue, there are also fairness issues at stake. Though their anonymity makes it hard to be sure exactly who holds cryptocurrencies, the signs are that ownership is heavily concentrated among the relatively wealthy, more so than is the ownership of shares. One estimate is that about 10,000 people hold one quarter of all Bitcoin. Effective taxation of cryptocurrencies is thus important to the overall progressivity of the tax system.
The greater revenue risk, however, may lie elsewhere. For now, cryptocurrencies are not widely used to buy goods and services (legal ones, at least). But if this were to become more common—and the “currency” part of the name is a reminder that they were created precisely for this purpose—compliance with value-added and other sales taxes might be at risk. For many years, tax administrations have tried to prevent traders from hiding their taxable sales by taking payment in cash—and they have had some success. But cryptocurrencies, with similar anonymity to that offered by cash, potentially reopen this battle. And VAT/sales taxes generally matter much more for revenue than do capital gains taxes.
All this gets pretty complicated, though there is one tax issue that, in principle at least, is straightforward: the creation of some cryptocurrencies, including Bitcoin, involves the use of huge amounts of energy (to solve, by way of billions of guesses, a mathematical problem). That is generating substantial carbon emissions on par with Bangladesh. The best response to the adverse climate impact of this is a generalized tax on carbon emissions. Failing that, specific tax measures can be aimed at the “mining” that generates these emissions. The US is indeed taking steps in this direction.
But in this, as in other aspects, much remains to be done to build tax systems that accommodate the new realities of crypto. The first step is to understand what the issues are, and that is what our paper tries to do.
“What’s in Your Wallet? The Taxation of Cryptocurrencies.” Katherine Baer, Ruud de Mooij, Shafik Hebous, and Michael Keen. Tokyo College Working Paper 2023.