Crypto-assets that can be used as a means of payment have grown in more than 10,000 variants since Bitcoin’s debut in 2009, the first and still the largest. The astonishing speed at which they have evolved and the pseudonymity they can provide has caused tax systems to catch up.
In a new paper, we discuss how governments can address the emerging challenges of taxing these crypto-assets while their use is still limited, preventing tax revenue leakage and protecting the integrity of the tax system.
The views on crypto assets are diverse and held with passion. The prospect of freeing financial transactions from government oversight and the involvement of financial institutions is a libertarian dream for some. El Salvador and the Central African Republic have even gone so far as to adopt Bitcoin as legal tender.
However, critics consider crypto-assets not only inherently worthless, but also a cover for crime, scams, and gambling. They also point to their dizzying volatility. For example, Bitcoin rose from $200 a decade ago to nearly $70,000 in 2021, only to drop to around $29,000 today.
Last year’s collapse of FTX and recent US Securities and Exchange Commission lawsuits against Binance and Coinbase have left users worried, while appeals to criminal activity have resulted in high-profile multi-billion dollar seizures. These developments have led to increased attention from policymakers and widespread calls for regulation.
But whether crypto assets eventually grow or break, a coherent way to tax them is needed.
An important point is how crypto assets should be classified: should they be considered property or currency? When crypto is sold for a profit, capital gains should be taxed like any other asset. And purchases made with crypto should be subject to the same sales or sales tax that would be applied to cash transactions.
Thus, an important task is to ensure these principles are applied, which requires clarity on how crypto should be characterized for tax purposes: essentially as a currency for VAT and sales tax purposes and as an asset for income tax purposes. While this is not easy due to the evolving nature of crypto asset transactions, it is perfectly possible. The biggest challenges then lie in enforcement.
Rough estimates suggest that a 20 percent tax on crypto capital gains would have raised about $100 billion globally by 2021 amid rising prices. That’s about 4 percent of global corporate tax revenue, or 0.4 percent of total tax collection.
But with the total crypto market cap down 63 percent from its late 2021 peak, tax revenues would have shrunk. If these losses were fully offset against other taxes, there would be a corresponding reduction in income. In more normal times and with the current market size, global crypto tax revenue would likely average less than $25 billion per year. That’s not a huge amount in the grand scheme of things.
There are also important issues of justice at stake. While their pseudonymity makes it difficult to know exactly who owns crypto, there are signs that ownership is heavily concentrated among the relatively wealthy, although crypto ownership is also remarkably common among low-income earners. Available surveys indicate that about 10,000 people own a quarter of all Bitcoin.
There is also VAT. Crypto transactions have similarities to cash in their potential to remain hidden from tax authorities. Today, the share of purchases with crypto is still small. But widespread use, if tax systems were not prepared, could one day lead to widespread VAT and sales tax evasion, leading to significantly lower government revenues. This is perhaps the biggest threat to crypto.
The most fundamental difficulty in taxing crypto assets is that they are “pseudonymous”. That is, transactions use public addresses that are extremely difficult to link to individuals or companies. This can facilitate tax evasion. Implementation is therefore the core of the matter for the Tax and Customs Administration.
The problem is surmountable when people transact through centralized exchanges, as they may be subject to standard “know your customer” tracking rules and possibly withholding tax. Many countries are introducing such rules with the expectation that tax compliance will improve.
However, reporting obligations can lead people to keep the tax authorities ignorant by using centralized exchanges abroad instead. To address that concern, the Organization for Economic Co-operation and Development has developed a framework for crypto-related exchange of information between countries. However, implementation is still a long way off.
A more disturbing possibility is that reporting rules (and the failure of some crypto intermediaries) could lead people to increasingly transact through decentralized exchanges or directly through peer-to-peer transactions where no central governing body oversees these transactions. These are still extremely difficult for the tax authorities to fathom.
Given the complexity of the fundamental challenges of pseudonymity, the speed of innovation, the huge information gaps and the uncertainties ahead, the battle to properly integrate crypto into the wider tax system has not yet turned. Some elements required for this, such as clarity in their classification for tax purposes, are obvious.
But the challenges are fundamental and the risks, particularly for VAT and sales tax, may be greater than people realise. As many (though by no means all) governments are realizing, policymakers need to develop clear, coherent, and effective frameworks for taxing crypto.