IMF Working Paper (Part II) How to Tax Cryptocurrencies?

IMF Working Paper Taxing Cryptocurrencies (Part II)

Author | Katherine Baer, et al.

Tax Evasion and Income Potential

From the beginning, the most concerning issue with cryptocurrencies and crypto assets has been their anonymity and the attractiveness it provides for facilitating criminal activities. There is no doubt that their criminal uses are widespread, whether it is in large-scale seizures (the largest being in February 2022, worth $3.6 billion in Bitcoin) or in significant (although temporary) price reactions. This also implies the dark side surrounding cryptocurrencies over the long term: there is a strong negative correlation between the use of Bitcoin and institutional quality/corruption control indicators. Specific areas of concern include “traditional” crimes – money laundering, drug and other illegal goods and services trade, financing terrorism, as well as new types of crime utilizing similar digital skills, including cyber fraud and ransomware attacks. Tax evasion is often included in this long list, but perhaps not surprisingly, it tends to rank lower. In fact, it is generally much easier to directly grasp the use of cryptocurrencies for criminal activities than for tax evasion activities. We will discuss each one separately.

A. Crime and Cryptocurrencies

Compared to the understanding of using cryptocurrencies for tax evasion, there is more knowledge about using cryptocurrencies for more serious crimes. This is because the nature of the technology – the entire transaction history and public keys on the blockchain are public information – provides meaningful clues to the extent of core criminal activities. Foley et al. (2019) used blockchain to identify addresses related to seizures and transactions on the dark web from 2009 to April 2017, based on over 600 million transactions. Based on this, they went further to establish groups of transactions deemed “directly” illegal and estimated a broader population potentially involved in illegal activities based on their characteristics (such as the use of “tumbling” and other obfuscation measures). Their final estimate was that around 25% of Bitcoin users were involved in criminal activities in 2017, accounting for approximately 23% (17%) of all transactions by volume (by value), holding about half of all Bitcoin. In terms of US dollars, this means that the transaction volume in 2017 was $76 billion and the Bitcoin holdings were $7 billion. These numbers are significant enough to conclude that “a significant part of the value of Bitcoin as a payment system comes from its use in facilitating illicit trades.” Chainalysis, a professional cryptocurrency analysis company, has found that the relative scale of illicit activities facilitated by cryptocurrencies is much smaller. According to Chainalysis (2022a), in 2017, “illicit addresses” accounted for about 1.4% of all transactions and received payments worth $4 billion. Makarov and Schoar (2021) also found relatively low numbers, with illegal transactions and gambling accounting for less than 3% of total transaction volume.

This is a significant difference. Makarov and Schoar (2021) attribute it mainly to the difference in the denominator. Unlike Foley et al. (2019), their own estimate does not include transactions related to transaction ownership and similar transactions that they do not consider to be “economically meaningful transactions”: these transactions account for about 80% of the total. While this helps reconcile these figures, it means that these transactions account for a considerable share in Bitcoin transactions related to actual activities.

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Although crypto crime is growing rapidly in absolute numbers and value, it is relatively declining, and this consensus has been reached. It seems that people also agree (although more as assertions than as proof) that criminal activities still largely rely on traditional financing methods, including cash.

Equally apparent is that cryptocurrencies are constantly innovating to enhance anonymity. For example, Monero operates on the blockchain but has characteristics of undisclosed public keys, transaction details, and other information. These cryptocurrencies are increasingly seen as the preferred choice for serious crimes. In response, the US Internal Revenue Service proposed in 2020 to enhance the ability to track Monero and other privacy key transactions.

B. Tax Evasion and Cryptocurrency

Since the proceeds of illegal activities are generally subject to taxation, estimates of the aforementioned illegal activities are likely to include some degree of tax evasion. However, for serious crimes that have been the focus of attention and investigation, tax evasion is likely to be just a byproduct rather than the main motivation. In fact, the widespread money laundering in cryptocurrencies aims to make illegal income appear legal, and there may even be a need to pay certain taxes as a result.

However, from a tax perspective, three questions are more important. The first is the nature of the motivation to use cryptocurrencies as a means of tax evasion for transactions that are originally legal, such as providing legitimate goods or services or paying wages. The second is to what extent cryptocurrencies are used or likely to be used for this purpose. The third is the extent to which taxes related to the generation or trading of cryptocurrency assets themselves are properly paid, such as mining income or sales proceeds. People know very little about these issues.

Regarding the first question, the nature of the consideration factors affecting tax evasion decisions is not fundamentally changed by cryptographic technology. Its essence is still as described in the literature starting with Allingham and Sandmo (1972): achieving a balance between the tax savings when tax evasion is successful and the losses suffered when tax evasion fails, with the probability of each case depending on the likelihood of detection. In this typical context, the significant feature of anonymity that cryptocurrencies possess naturally makes them particularly attractive as a means of tax evasion due to their perceived low probability of detection. However, there may be other considerations in the calculation.

One consideration is transaction costs, which are both related to whether to evade and to the choice of evasion means. In this regard, the balance point of advantages between cryptocurrencies and the obvious comparison object cash is not a priori (and may change over time). For example, compared to cash, cryptocurrencies may save some transaction costs because existing channels for transactions can sometimes be more expensive. For example, a remittance of $200 is estimated to cost 5.7%, while the transaction fee for Bitcoin is only 1.4% (Beck et al., 2022). However, using and leveraging Bitcoin to enhance anonymity may require acquiring certain skills, which can be costly. Over time, the latter barrier to using cryptocurrencies (excluding any regulatory restrictions) is likely to decrease.

Another unique consideration is the risk implied by the high price volatility of cryptocurrencies. The risk of fraud or theft increases to varying degrees in the process of using cryptocurrencies, which can have similar effects. Similar to exchange rate risk, the main consequence may be to prevent the use of cryptocurrencies to mitigate risks. Restricting cryptocurrencies may lead to tax evaders cashing out faster than those who hold cryptocurrencies for investment purposes, and the above research suggests that this characteristic is associated with cryptocurrency-related crimes.

In the second quantitative issue, there is almost no definitive evidence, even rumors, to explain to what extent cryptocurrencies have fostered tax evasion. In May 2022, Indian authorities seized nearly $1 billion in tax evasion goods and services tax from local exchanges. In the UK, cryptocurrency assets and NFTs seized by the UK’s HM Revenue and Customs clearly indicated VAT fraud. Interestingly, both of these stories are unrelated to income tax and are related to VAT. Compared to traditional forms of tax evasion, there is a lack of definitive evidence on the likelihood of tax evasion related to cryptocurrencies, which we will further speculate in the next section.

Regarding the third issue, there is some information contrary to tax evasion: tax compliance. In the case of the United States, the research results of Hoopes et al. (2022) indicate that about 1% of all tax returns in 2020 reported some cryptocurrency sales. This is far lower than the estimated 10-20% of US adults holding cryptocurrencies at the time, as shown by survey evidence; of course, some filers may have simply chosen not to report it. In the UK, there are also signs of at least some level of compliance: a survey conducted for HM Revenue and Customs (HMRC) showed that 45% of cryptocurrency holders believed they might need to pay capital gains tax, and 34% believed they had a good understanding of the relevant rules. The survey also showed that nearly 30% of holders had sought guidance on tax treatment of cryptocurrencies — it is speculated that most people’s intention was to comply with the regulations rather than seek how to evade taxes. While this may indicate that people’s understanding of cryptocurrencies is quite widespread, it is far from comprehensive, as many people hold such small amounts of cryptocurrencies that it is almost certain that any gains would be below the tax-free threshold. However, cluster analysis shows that only one group (Group “A”) has income (or losses) related to taxation, where 90% of people believe they have a good understanding of capital gains tax and 72% have read guidance from HMRC. Of course, understanding one’s tax obligations does not necessarily mean an intention to comply with them; it is worth noting that people in Group A are also more likely to trade outside of centralized exchanges, including peer-to-peer transactions, which are more difficult to monitor. The more common scenario is that those who are determined not to comply with the regulations seem unlikely to respond to surveys. While these results may be somewhat reassuring, they are still far from sufficient.

Cong et al. (2022) sought signs of tax compliance by examining the extent to which US cryptocurrency holders harvested tax losses at year-end by selling and immediately repurchasing cryptocurrencies to realize losses while maintaining their holdings – a transaction that is difficult to justify outside of tax planning. (For traditional securities, such gains are restricted as they do not consider repurchases within 60 days of selling; however, as one of the gray areas of cryptocurrency tax accuracy, this restriction is considered not applicable to cryptocurrencies). Cong et al. (2022) used proprietary data from 500 large retail brokers and data from 34 exchanges to find that such cryptocurrency transactions do exist, and such transactions increased after the US Internal Revenue Service emphasized the tax obligations of cryptocurrency transactions and its targeted enforcement intentions. However, the conclusions drawn from this are somewhat mixed: while there is a certain level of compliance, the impact of IRS policy statements suggests that there are or at least have been non-compliant consequences, whether intentional or unintentional.

C. Tax Potential

All of this leaves us with little knowledge about the amount of income involved in taxation or tax evasion. Perhaps the closest to this goal is Thiemann’s (2021) study. The study used bitcoin transaction data provided by Chainalysis, linked to the user’s country of residence probabilistically (through network traffic information and time differences, among other clues), to estimate accrued and realized capital gains for EU residents. Although there is no information about the actual payment of capital gains tax on these transactions, this can roughly estimate the tax liability due – which in turn can be seen as an upper limit on the amount of tax evasion. By 2020, this amount is estimated to be 850-900 million euros. It is difficult to compare this figure with the tax revenue from personal capital gains tax in the EU, as many countries do not report this figure. But for example, Thiemann (2021) points out that this accounts for about 0.3% of total property tax revenue in the EU; in comparison, the capital gains tax revenue in the UK alone (excluding the sample) is about 12 billion euros.

In addition, our understanding of this area is very limited, and even the most rudimentary reverse calculations may be helpful. In this spirit, one approach is to treat cryptocurrencies as an investment asset and apply some assumed rates of return and tax rates. For example, assuming a total market value of cryptocurrencies of $1 trillion (compared to an estimated global “hidden wealth” of about $7 trillion for scale purposes). Assuming a rate of return of 5% (taking into account that returns are closer to normal levels than in the past) and a tax rate of 20% (ignoring the complexity and diversity of tax systems in various countries), the implied total tax liability would be $10 billion. If calculated based on a market valuation peak of $2.6 trillion (November 2021), the annual tax liability would be $260 billion.

From a global perspective, these numbers seem small, even the latter, which accounts for only about 1% of global corporate income tax revenue. However, although a assumed return rate of 5% may approximate some stable state of cryptocurrency, there is little evidence to suggest that cryptocurrency is approaching this normal state. On the contrary, past cryptocurrencies have always been characterized by significant volatility. Looking back at the past two years, it can be seen how precarious the income is. In 2021, the market value of cryptocurrency increased from $752 billion to $2.368 trillion; in 2022, the market value dropped to $836 billion. These numbers are approximate values of accrued capital gains (for example, the quantity of Bitcoin increased by only 2%, and these newly generated Bitcoins also need to pay income tax). Similarly, assuming a tax rate of 20%, by 2021, the tax revenue from accrued capital gains tax will reach $323 billion, accounting for about 12% of global corporate income tax revenue. Even if only one-third of the revenue is realized, the tax revenue will still be around $100 billion. On the other hand, in 2022, if the loss is fully offset by other income, the reduction in tax loss will be similar to this – although loss offset can also be limited by imposing a tax fence on cryptocurrency assets.

Given the high concentration of the aforementioned holdings, the tax on realized gains (and loss offset) on the largest holdings will be correspondingly high: for example, in 2021, the implicit tax on realized gains on these 116 largest addresses will reach approximately $1.7 billion. In a “normal period,” this number is about $140 million.

We can also consider imposing a financial transaction tax on cryptocurrencies, similar to the tax sometimes proposed or applied to securities transactions, which can increase revenue – although this is not a recommendation, it should also be considered in the context of the corrective measures discussed above. For example, according to the pending proposal by the European Commission (2011) to impose a tax rate of 0.1% on securities transactions, if applied to all cryptocurrency transactions reaching $15.8 trillion in 2021, the revenue will reach approximately $1.58 billion.

Another approach is to focus on the use of cryptocurrencies as a means of payment. The difficulty here is that some transactions are theoretically subject to full taxation (such as final consumer purchases of goods and services or property), while others (purchases of business inputs, including wages) can be fully or partially deducted. However, even if the latter case is given lenient consideration, it also indicates that large amounts of money may be affected. For example, assuming all cryptocurrency transactions are conducted in the form of value-added tax chains, and the final sales account for 5% of the total transaction value. The total transaction amount in 2021 is $15.8 trillion, and calculated based on a value-added tax/sales tax rate of 15%, the implicit income loss will amount to $118.5 billion. Of course, many current transactions may be associated with serious crimes, and in this sense, it may be more difficult to recover tax revenue from illegal activities than from legal activities. However, if only 2% of transactions are legitimate final sales, the implicit income will still reach a considerable $47.4 billion.

These calculations are too simplified, and there are also more considerations (such as assuming that changes in taxes will not affect the quantity or value). Of course, since some potential taxes may have already been collected, these calculations do not indicate how much tax evasion there is. The US Joint Committee on Taxation (2021) estimates that in the first year of implementation of new cryptocurrency reporting requirements, the revenue (which may be additional revenue generated by self-reporting or other reporting, and may also be affected by cumulative losses since 2021) will be $1.5 billion, increasing to $4.6 billion by 2031. This is approximately one percent of the total capital gains tax revenue (federal, state, and local) in 2020.

All of this provides lessons. First, globally, there is a risk of income of up to billions of dollars, and if cryptocurrencies perform well, it could even approach hundreds of billions of dollars. However, how much of it can be recovered is another matter: even without considering tax evasion detection issues related to quasi-anonymity, controlling serious criminal behavior is far beyond the capacity of tax authorities. Second, most of the controversial income is related to large cryptocurrency holders. Third, in terms of taxation, treating cryptocurrencies as a currency for legitimate transactions rather than investment purposes may attract greater attention. The focus on cryptocurrencies in tax literature mostly revolves around income tax issues; however, the most important issues may arise in value-added tax and sales tax.

The Core of the Issue: Implementation

In any field, a prerequisite for effectively and efficiently implementing taxes is to provide clear and complete explanations of the rules to be implemented. However, even in some of the most advanced countries, some important details are still unclear. In fact, the development of this field is so rapid, and it has been proven difficult to adapt to these developments within the existing legal framework, that tax rules attempting to passively keep up with the pace of technological and financial innovation may take some time.

A. The Impact of Anonymity

The fundamental obstacle to tax enforcement related to cryptocurrencies is the anonymity factor. The discussion in this article expresses the novelty of this problem (paraphrased): in the past, the problem for tax authorities was that they knew who you were, but did not know your income; now, the problem is that they know your income, but do not know who you are. Literally, this statement is somewhat misleading: income may be difficult to identify from transactions (which will be explained in detail later); and, this is not just an issue of tax authorities being unable to identify individuals—no one can. In addition to income tax, we must also not overlook other taxes, especially goods and services taxes; for these taxes, information about the purpose of the transaction is also needed (which may be very precise). Nevertheless, this proverb still conveys an important truth, that the problem posed by the use of cryptocurrencies is not how to identify transactions, but how to link them to specific entities and distinguish their purposes, which is a problem that has never been encountered before. This is also not an accidental byproduct of the development of cryptocurrencies. The emergence of cryptocurrencies is precisely due to an intention (whether for liberal or criminal purposes) to provide a means of conducting financial transactions without involving the government or any central institution capable of providing third-party information. Overcoming pseudonymity, which lacks intrinsic motivation for self-reporting cryptocurrency transactions (except perhaps when incurring losses), is the core problem that tax administration departments are currently trying to address.

However, it is worth pausing to consider the significance of anonymity in the implementation of taxation. Anonymity itself, the inability to link transactions to specific individuals or legal entities, is not fatal to any form of taxation. A transaction tax with a single rate does not require taxpayer identity information; in the case of blockchain, what hinders its anonymous implementation is the inability of tax authorities to insert themselves into the chain. Similarly, a uniform income tax does not require the identification of taxpayers’ identities; however, it does require information about the nature of the transactions, which cannot be obtained on the blockchain (e.g. to identify interest payments). More complex tax structures (non-linear income taxes, or value-added taxes involving both deductions and output taxes) require some means of identifying different transactions by the same individual in order to aggregate them, including transactions conducted through means other than cryptocurrencies. In this case, if all transactions were conducted in cryptocurrencies, individuals or companies would have a unique digital identifier, and we can imagine using smart contracts to fully implement complex tax systems on the blockchain—without tax authorities needing to identify the real individuals and companies behind these identifiers. Privacy in this regard can be fully respected and, in principle, avoid the utopian prospects that some people think blockchain data centers will eventually bring. However, whether governments will give up the ability to establish some form of personal identification is questionable.

However, in the foreseeable future, the challenge for tax authorities, while not so profound, is still challenging, which is how to adapt to the pseudo-anonymity of cryptocurrencies in the system.

B. Addressing Anonymity Issues

For tax authorities and regulatory agencies, the good news is that—contrary to the initial vision of cryptocurrency designers—various centralized institutions have emerged as key players in cryptocurrency asset transactions, especially through exchanges. These institutions have the ability to obtain ownership information, making them the core of ongoing efforts to gather useful third-party information that can be shared with tax authorities, although these efforts may be somewhat slow and certainly incomplete.

Using intermediaries to acquire or cash out cryptocurrencies in exchange for fiat currency or other traditional instruments is a natural point for tax authorities to gather information. For this purpose, an important step is to ensure that anti-money laundering (AML) regulations apply to those who provide services related to cryptocurrency transactions. Key anti-money laundering requirements include “know your customer” (KYC) rules for verifying identities—within the cryptocurrency environment, at least on centralized exchanges, the private key should be able to be linked to the beneficial owner—providing suspicious transaction reports (STRs) and attaching customer information to transactions (“travel rules”). In the United States, in 2013, the applicability of anti-money laundering rules to cryptocurrency transactions was clarified, and more broadly, in 2015, the FATF issued guidance on the application of established standards. At the EU level, previous regulations only applied to “banknotes and coins, scriptural money, and electronic money,” excluding cryptocurrencies; the European Commission has proposed appropriate updates to the regulations based on FATF guidance, which are currently awaiting approval by the Council. It is the KYC provisions that provide the information basis for the IRS to issue “John Doe” notices to cryptocurrency brokers, requesting them to provide information about U.S. taxpayers who have transacted $20,000 or more in cryptocurrencies between 2016 and 2021. In the UK, they enable HMRC to send targeted letters to cryptocurrency owners, reminding them of their obligations. Additionally, when “tax crimes” are identified as predicate offenses for money laundering, tax authorities can, in principle, obtain information collected by financial institutions based on anti-money laundering rules.

However, in practice, from a tax perspective, anti-money laundering rules alone are usually not enough (not only for cryptocurrencies, but also in a broader sense). After surveying its 28 members, the OECD (2015) reported that only 20% of tax authorities have direct access to suspicious transaction reports, so they heavily rely on financial intelligence agencies voluntarily sharing information they deem relevant to taxation. Even serious tax evasion may not trigger a suspicious transaction report. Since the OECD survey, the channels for tax authorities to obtain anti-money laundering information may have improved. However, expanding anti-money laundering rules to cryptocurrency transactions, although important for other purposes, is clearly not sufficient for effective taxation. For example, KYC rules may let authorities know that someone has cashed out a certain amount of cryptocurrency; but without further information, it is not possible to determine any relevant capital gains or losses from previous transactions recorded on the blockchain.

In addition to anti-money laundering, tax authorities naturally also want to be able to directly and automatically share cryptocurrency transaction information with them, as is widely practiced in traditional financial transactions. Currently, this has become a widespread concern. In the United States, the Infrastructure Investment and Jobs Act (IIJA) enacted in November 2021 includes two relevant provisions that require (1) broadly defined digital service providers (including possibly miners) to report their customers’ transaction details to the IRS annually, similar to bonds and stocks; (2) all businesses to report cryptocurrency asset transactions exceeding $10,000, mimicking existing cash payment rules. These two provisions will take effect from the 2023 tax year. Similar measures are also being taken elsewhere. For example, in Brazil, the Federal Revenue Office issued regulations in 2019 that require legal entities and individuals to report business conducted using cryptocurrency.

However, applying reporting rules to domestic institutions may encourage transactions to flow to domestic mechanisms not subject to these rules or foreign mechanisms that do not provide information to domestic tax authorities. Cong et al. (2022) found evidence of the latter effect in the United States, where they found that actions taken by the IRS against US taxpayers seemed to increase legitimate tax evasion activities in the cryptocurrency market, but actions taken against a specific US exchange (Coinbase) decreased activities of US exchanges. In the UK, a survey by HMRC (2022a) found that 22% of respondents preferred to use foreign exchanges.

The key tool to address this problem is cross-border information exchange, reporting assets and income to the country of residence. However, existing frameworks did not consider cryptocurrency or crypto assets when they were built, so there is a possibility of falling into a gray area. Recognizing this issue, the OECD (2022) has developed a framework for the cross-border exchange of cryptocurrency transaction information between tax authorities, parallel to the framework already in place for traditional financial assets and fiat currency. This assumes that domestic authorities have already established requirements similar to the above, including requirements for non-residents—so there may still be a long way to go for implementation—but it provides an environment where common rules can be developed; for example, the EU seems to have been waiting for the outcome of this work by the OECD to draw lessons among member states. It is important to note that the OECD’s framework not only reflects concerns about the impact of crypto assets on income taxes, but also concerns about value-added tax and sales tax: including a reporting requirement for the purchase of goods and services with crypto assets exceeding $50,000. However, widespread adoption of the OECD’s provisions (2022) is still a somewhat distant prospect. During this period (which could be lengthy), entities can avoid information reporting simply by “locating servers in jurisdictions that authorities are willing to tolerate their existence.” In fact, experience has shown that as some jurisdictions adopt international standards for information exchange, information-sharing activities often shift to other jurisdictions.

Therefore, there is still a long way to go for an effective mechanism for third-party reporting by central authorities involved in cryptocurrency transactions, including cross-border transactions. But at least we can see how they are playing a role. The most difficult problem is still direct peer-to-peer transactions, including those facilitated by decentralized exchanges.

Decentralized exchanges fundamentally cannot fulfill the reporting obligations currently required in the United States, perhaps because of this, although the United States did not exclude decentralized exchanges from the reporting requirements of the Infrastructure and Employment Act, it did not explicitly include them either. The reporting requirements envisioned by the OECD (2022) will include any decentralized exchange, “as long as it exercises control or sufficient influence over the platform to enable compliance with due diligence and reporting obligations” – which in most cases is unlikely to happen. In fact, it is very difficult to assess to what extent current cryptocurrency transactions are peer-to-peer rather than conducted through centralized exchanges. For example, FATF has asked seven blockchain analysis firms to assess the proportion of peer-to-peer Bitcoin transactions: estimated values ​​range from almost zero to almost 100%. In HMRC (2022a), only 8% of people reported using decentralized exchanges; however, in Group A, which is most relevant to taxation and has the most knowledge of taxation, this number rises to nearly 50%.

Regardless of its current importance, what we need to focus on is that as information reporting becomes more effective in centralized transactions, transaction activity will also shift towards decentralized forms, which these rules are actually unenforceable for. For this reason, more innovative approaches may be needed.

For example, an alternative approach may be to focus not only on institutions similar to financial institutions reporting information, but also on requiring miners themselves to report information. These miners are involved in every cryptocurrency transaction and their numbers are relatively small – which is always useful for tax management (although not so popular for the security of cryptocurrencies): according to Makarov and Schoar (2021), by the end of 2020, about 55-60 Bitcoin miners controlled more than half of the Bitcoin mining capacity. From these perspectives, they are attractive points for requesting information reporting. We can even imagine going further and levying some corrective transaction taxes at this point (if determined to be helpful) and/or applying (deductible) withholding obligations: charging fees for each transaction paid to the relevant tax authorities and deducted/refunded by them. These obligations can be fulfilled in various ways. The traces left by miners in the blockchain may help identify them as real entities. In addition, some incentives can be taken to encourage them to comply with the law, if not in the form of explicit subsidies to law-abiding citizens (which may not be effective), then in the form we are familiar with, that is, allowing the delayed payment of withholding taxes to the authorities concerned.

However, at least in the near future, tax authorities in most countries must deal with very limited directly available information regarding the holding and trading of cryptocurrencies. Of course, this does not mean that they are powerless.

What is beneficial to them is the abundance of information publicly available in unauthorized blockchains. This provides space for the application of blockchain forensic analysis technology; the analysis discussed above provides some experience in this regard, for example, some companies hope to link legal names, accounts, and IP addresses with virtual asset service providers (such as cryptocurrency exchanges). Artificial intelligence applications can draw on past experience to identify potential tax-related behavior, and of course, traditional investigative methods also have room to seek connections with off-chain information.

In addition, there are other more standard measures to encourage self-reporting, such as taxpayer education (including general education and targeted education) and advice. Large-scale successful actions can be used to convey the appropriate chilling message: for example, the FBI “is even able to expose the sources of the most complex schemes and bring those who attempt to exploit the security of our financial infrastructure to justice,” and in the UK, the seizure of NFTs “is a warning to anyone who thinks they can use cryptographic assets to evade UK tax and customs authorities.” Given the profound challenges posed by quasi-anonymity, the astonishing pace of change in this field, its technological complexity, the huge information gap, future uncertainties, and the struggle to properly incorporate cryptocurrencies into a broader tax system, people may sense some whistling in the dark from these statements. In any case, achieving these confident assertions is clearly not an easy task.

C. Value Added Tax and Sales Tax

Regarding the impact of cryptocurrencies and, in a broader sense, cryptographic assets on taxation, most discussions focus, whether explicitly or implicitly, on income taxation, particularly capital gains taxation. However, looking ahead, some of the greatest risks facing the broader tax system may be related to value-added tax and sales tax.

Currently, the use of cryptocurrencies for directly purchasing goods and services is apparently limited and is not a characteristic of everyday life (even in places where Bitcoin is a legal currency). In fact, in certain aspects, as mentioned above, the current tax rules may hinder the use of Bitcoin as a means of payment, but if such use becomes widespread, it could pose potential significant risks to the integrity of the value-added tax and sales tax systems. An obvious risk is that the widespread use of cryptocurrencies may facilitate underreporting of final sales figures. This is not a new problem: in fact, for decades, tax administration has focused on addressing this risk, especially related to cash purchases. Some success has been achieved in this regard. However, cryptocurrencies may open up a new front in this battle, using new complex weapons.

The first line of defense is the legal requirement for all enterprises to report large cryptocurrency transactions, as mentioned earlier, which has already been implemented in the United States and is also envisaged by the OECD (2022). These rules are clearly not sufficient to control the risks faced by the above-mentioned tax systems: they are neither self-enforcing nor comprehensive. Moreover, they also face the same difficulties as the above-mentioned decentralized transactions or unreported foreign exchanges. However, they are almost necessary in terms of generating alerts, providing audit clues, and increasing the negative risks of tax evasion.

For value-added tax, further challenges may arise in using cryptocurrency as a convenient means of fraud, such as creating carousels to enable unpaid taxes to claim refunds. This is also not a new problem, but the use of cryptocurrency may bring about new forms of problems.

For how to protect sales tax and introduce more complexity in value-added tax to deal with these challenges, there seems to be no systematic thinking yet. For the time being, the risks appear to be more potential than real. But this situation can change.

VI. Conclusion

The future of cryptocurrency is highly uncertain. For some, cryptocurrency is a bubble that will eventually burst completely. For others, cryptocurrency will lay the foundation for fundamental innovation in decentralized finance. However, regardless of the case, the tax system needs to adapt to them with coherence, clarity, and effectiveness. The current tax system lacks such coherence, clarity, and effectiveness because it did not consider crypto assets when it was constructed. In addition, they also need to achieve this on the basis of limited information in the context of continuous rapid and complex innovation, while balancing the core goals of tax efficiency, fairness, and revenue with the risks of stifling innovation. These challenges are both conceptual and practical.

Conceptually, cryptocurrency has the dual nature of investment assets and payment tools—the latter, although not as prominent as the former, is the main purpose of its development—this creates potential difficulties in how to obtain capital gains and losses of its asset role without hindering its use as a currency. Regarding value-added tax and sales tax, although many detailed issues will arise, a key step is to ensure that cryptocurrency is treated the same as national currency. The need for income tax (such as providing exemptions for reasonable personal currency use) will depend on the existing national profit and foreign currency transaction handling structure.

Issues related to the potential corrective effect of taxes also arise, such as whether it is to address internal issues related to gambling or to serve as a stopgap measure before effective regulation is implemented. More specifically, and the focus of some current actions, is the collection of some fees—preferably as part of a broader carbon tax or not as fees for specific sectors—to address the significant impact of the proof-of-work consensus mechanism on the climate.

However, the implementation of cryptocurrencies brings about the most serious issues. This is because the essence of cryptocurrencies and the core motivation behind their development is precisely to avoid trust in central institutions, which may be able to provide information to tax authorities or impose some form of withholding tax. Nevertheless, the first step for governments around the world is to apply anti-money laundering rules and third-party reporting requirements, as recently done in the United States whenever possible. However, the risk is that transactions will to some extent migrate to forms that are invisible to third parties (on decentralized exchanges or directly peer-to-peer). Ironically, from the original vision of cryptocurrencies, investors may trust well-regulated institutions more than the “wild west” of decentralized trading. It is more likely that miners—who do see every transaction of non-stablecoins—could in principle be assigned a role in taxation/withholding tax, which is in line with the general principles of tax administration to collect taxes at as few upstream points as possible.

In addition, because cryptocurrency transactions are easy to conduct across borders, domestic tax measures may also lead to transactions shifting to non-declared platforms abroad, exacerbating these difficulties. The OECD (2022) has developed a framework to extend the current cross-border information arrangements to cryptocurrencies, but it will take time to implement in the future and, in any case, it does not solve the challenges brought about by decentralized trading.

It is difficult to assess to what extent the pseudo-anonymity of cryptocurrencies facilitates tax evasion (except for tax evasion related to blatant criminal activities, which is decreasing in the cryptocurrency space). However, there is evidence that at least in the United States, there is a certain level of compliance, with about one percent or more of people reporting cryptocurrency sales and signs of substantial tax evasion activities. In terms of the amounts involved, rough calculations suggest that in the “good” year of 2021 for cryptocurrencies, approximately $300 billion (about 12% of global corporate income tax revenue) could be raised from the 20% global tax on capital gains. However, in the “bad” year of 2022, this revenue could be eroded by substantial capital losses.

As for those who may have taxable income, although information is limited, there is solid evidence that cryptocurrency wealth is highly concentrated, even more so than stock ownership. It appears to be not just a matter of a few cryptocurrency billionaires or a few individuals getting rich through cryptocurrency investments, but a broader and less known issue of wealthy individuals holding cryptocurrencies whose wealth comes from other sources. Of course, the underlying problem here may not be specific to cryptocurrencies but also applicable to capital gains taxes on other assets, especially at the top end of income distribution. However, it is worth noting that in the UK and the US at least, many cryptocurrency holders are far from being wealthy individuals, with incomes lower than other investors and typically only at a moderate level.

The literature on the taxation of cryptocurrencies mainly focuses on income tax, which is indeed the most relevant aspect of taxing the wealthy and is the theme of this issue. The impact of sales tax, especially value-added tax, receives much less attention. However, these impacts can be far-reaching, as cryptocurrencies can create issues similar to those with cash use, and value-added tax has long been working to address these issues and may create new opportunities for fraudulent activities. It is in this area that the use of cryptocurrencies poses the most profound risks to existing tax systems – especially in emerging and developing economies, where the demand for cryptocurrencies seems relatively strong while tax administration remains relatively weak.

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