Summary:

  • The friction between crypto and nation states is fundamentally about tax.
  • Tax compliance issues with earning, exchanging and selling crypto are under-appreciated by crypto protocols, crypto users and governments.
  • Some crypto users seek to be tax compliant. This will force crypto protocols to improve tax accounting tools - an example of the minority rule.
  • Certain nation states may adapt their tax systems to crypto. This may mean reducing reliance on income and capital gains taxes in favour of a reversion to taxes on physical goods (real estate tax, value added tax).
  • Universal basic income may be adopted because - with crypto held in private wallets - we may not know who is poor and who is rich.

An updated version of this article is maintained here.

Nation States vs Decentralised Crypto

For some, crypto is fundamentally extragovernmental (outside of government); to discuss taxation is to acquiesce to crypto being controlled by nation states. For others, crypto can only avoid sanction and thrive by working with government rather than around government. Both positions may prove to be correct: some governments are adapting to crypto, and some crypto platforms are adapting to nation state governments.

Note: When I say crypto, I mean "decentralised crypto". Crypto could very much be centralised, for example the Yuan cryptocurrency being piloted by China.

Nation States - A Matter of Purse by Sword

The power of a nation state is underpinned by force. This power underwrites the ability to tax and issue currency.

Crypto - A Matter of Consensus

There is no sword in crypto. The power of crypto relies on consensus. People agree to adopt a decentralised record (the blockchain). Continuity of consensus requires a robust record keeping system. Robustness drives adoption.

Crypto v Nation States - a Battle about Tax

The friction between crypto and nation states is fundamentally about tax. It cannot be about the sword because crypto does not have a sword.

Crypto - which may be held on a piece of paper - is not easily tracked. The more of the economy that moves to crypto, the less of the economy that can be tracked.

Consider two lenses for this battle:

  1. Crypto Adapting to Nation States
  2. Nation States Adapting to Crypto

Crypto Adapting to Nation State Taxes

From a tax perspective, crypto is often treated much like a foreign currency. Here are some events that are typically taxable as ordinary income:

a. Crypto donations - e.g. you receive a 0.1 BTC donation.

b. Crypto earnings for work done - e.g. you get paid in Bitcoin for consulting work.

c. Platform emissions - e.g. you earn more FARM tokens for staking your FARM tokens on harvest.finance OR you earn Celo tokens for holding a balance of cUSD on the Valora App. Technically, many states require you to keep a record not just of what cryptos you earn, but also the value of that crypto (in the state's currency) at the time you earned it. Income tax is paid on that amount. Capital gains tax is often payable on any appreciation in value beyond.

d. Crypto capital gains - e.g. you buy 1 BTC for $3,000 and then you sell it for $50,000.

e. Crypto conversions - e.g. you buy 1 BTC for $3,000 and then convert it into Ethereum at a later point in time when BTC is worth $30,000 and ETH is worth $1,500. In this case, many countries require you to pay capital gains tax based on the conversion price of BTC - even if you are converting the BTC into ETH not US dollars, for example.

While points a, b, d and e are each tedious, the administrative work involved in part c is particularly under-appreciated. Many governance tokens emit new tokens monthly, weekly or even daily. While some trading platforms (e.g. Coinbase) have limited tax tools, many platforms and protocols are not design to facilitate accounting.

This brings me to ideas (not necessarily recommendations) for addressing the above tax challenges at the personal level:

  1. Live in a country with no capital gains tax (e.g. Singapore, New Zealand), and ideally, also no income tax!
  2. Focus on buying tokens that appreciate in value but do not earn emissions or profit share. For example, Uniswap tokens currently do not earn any emissions. This is analogous to owning shares in a company that does not pay out dividends*, like Berkshire Hathaway or Google.
  3. Overpay tax. Typically, income tax rates are higher than capital gains tax rates. If you can't track the price at which you received crypto income, it may make sense to pay income tax on its value at year end. In a bull market for crypto, this means you will overpay on tax, but it does simplify accounting (provided your country accepts this approach).

Not everyone will necessarily want to be tax compliant, but there will be a cohort of crypto users that do. According to the "minority rule", this users will drive crypto protocols and platforms to build accounting features that make the filing of tax returns simpler. I see this as a rising area of competitive advantage among custodians and protocols.

Nation States adapting to Crypto

While certain crypto protocols will work to facilitate tax compliance, certain governments will take steps to facilitate crypto. Those steps may include:

i. Allowing payment of taxes in crypto.

It is difficult to imagine this in currency strongholds like the US, China and the EU. However, certain small nations may allow for taxes - or at least certain taxes - to be payable in crypto. I see this as increasingly likely if states move to include crypto in their foreign currency reserves or sovereign wealth funds. However, even if taxes are payable in Bitcoin, for example, i would expect taxes would still be calculated on a fiat currency basis. [Calculating taxes based on Bitcoin prices would not make a lot of sense. Given Bitcoin is deflationary, other assets would be reporting capital losses rather than capital gains in a Bitcoin bull market.]

ii. Move away from income and capital gains taxes.

Today, income is predominantly paid out by limited liability companies, governments and sole traders. All are directly regulated through tax audits and indirectly regulated through the banks that they hold their money in. [in having a bank account, you are often providing some possibility of government access to your transactions because banks are typically regulated]. A crypto protocol like Bitcoin is none of these things. Bitcoin doesn't issue a tax document at the end of the year to miners who earned block rewards.

In the medium term, more and more of the income in the economy may move from being paid by corporations to being paid by protocols. The proportion of wealth comprised of digital assets on the blockchain may also increase. If income and wealth does move to the blockchain, income and capital gains taxes will become increasingly difficult to implement - particularly given the international nature of digital assets and protocols.

iii. A reversion to taxes on physical goods and the growth of universal basic income

If a greater share of income and wealth is handled by decentralised blockchains, it becomes more difficult for nation states to tax income and wealth.

The alternative is a reversion to the taxation of physical assets within a nation state's borders. Keep in mind that income tax is a relatively modern phenomenon that emerged in the 1900s.

A carbon tax, or taxes on other externalities, may provide another alternative to taxing income or capital gains.

With taxation shifting to real estate, value added tax and taxes on externalities, it may prove difficult to maintain a progressive tax system as is currently in place with income taxes in many countries. This may give rise to a need for universal basic income.

The question of progressive taxation may become a moot point because it will be difficult to determine wealth and income when on the blockchain.

Ultimately, universal basic income may be adopted not because we need to replace progressive taxation but because we may not know who is poor and who is rich.

In Conclusion

Staying tax compliant is a significant burden for those invested in crypto. Protocols would do well to incorporate tax tools in their software to make it easier for those who seek compliance. I expect this will increasingly be the case and become a point of differentiation between protocols.

Governments may at first seek to apply their current tax approach to the crypto economy. However, enforcement will persist an issue and potentially lead to governments taking a different approach to taxation for the crypto economy. Taxation for the crypto economy may involve a combination of taxes on physical goods and taxes on externalities, as well as the introduction of universal basic income.

*A technical note on the taxation of "buy and burn" governance tokens

Certain tokens operate in a way that any profits the tokens earn is used to repurchase that same token on the open market. This is analogous to share buybacks, and is one way that traditional corporations can return value to shareholders without causing a taxable event. [By buying back their own shares, the total number of shares outstanding is reduced, which increases the share price.]

However! Crypto governance tokens are not corporations recognised by governments. As such, my thinking is that owning a crypto token with a profit share may be treated as owning a share in a partnership - not as owning shares in a corporation. Whether or not profit share is directly distributed to governance tokens or used to repurchase governance tokens, nation states may claim that any profit share is taxable income.

One concrete example here is FARM tokens, which benefit from profitshare being used to buy and burn FARM tokens. It is possible that this profit share would be taxable income to FARM token holders. The only way to avoid this would be for Harvest.Finance to register as a governmental corporation and start paying corporate tax on profits! This is obviously not going to happen.