Crypto & Taxes: Could the Two Coexist?

Tax is making crypto complicated, or is crypto making taxes complicated? In any case, cryptocurrencies and taxes are like two forces that were never meant to coexist. One gives the power of information to individuals while the other wants to extract power through information. Yet, we live in a world where they do, and are left to navigate.

Note — this is not a “How to Do your Crypto Taxes” guide. Feel free to message me if you need help. Rather, this is a more high-level thought behind crypto and taxes.

Tax is a looming problem to solve in the cryptocurrency space and probably one of the biggest barriers to crypto adoption. Currently, cryptocurrencies are largely used for investment purposes and most taxing authorities treat cryptocurrencies similar to other investment assets. You pay capital gain/loss whenever you dispose of your cryptocurrency. However, we are seeing a proliferation of innovations that is unlocking the potential of cryptocurrency to become more than just another form of investment asset but a form of decentralized currency. And a decentralized currency could have the potential to leave the tax authorities irrelevant, especially with the current tax treatment of cryptocurrencies.

For instance, with the rise of DeFi (“Decentralized Finance”) protocols, cryptocurrency acts like a currency rather than just an investment asset. In the DeFi world, people can trade cryptocurrencies, earn interest on the cryptocurrencies, and even earn different types of crypto assets without any centralized governing entity. And since these DeFi protocols function without any centralized governing entity, any user can interact with these protocols with just a connection to the internet and without any identity verification. However, that also means there is no information being sent to the tax authorities for them to reconcile trade activities with the tax returns, making it difficult for tax authorities to ascertain the tax liability amount.

As cryptocurrencies become more widely adopted, beyond the DeFi world (or with the assimilation of the DeFi world to the real world), the rise of decentralized currency could lead to individuals having the sole knowledge and information to calculate and pay their tax liability amounts. The taxing authorities would have to trust individuals to report accurately and pay their fair share of taxes due to the lack of information access. The power and choice to pay taxes could shift from the taxing authorities to the individuals. A tax system that revolves around trust and choice of the individuals rather than enforcement and coercion. Would that kind of system work? Hard to imagine — considering that most people are not incentivized to pay taxes but rather do so out of fear of retribution.

So, then, what are some approaches the tax authorities could take?

Some authoritative approaches could include:

• Investing in massive data analytics to track all crypto-transactions to create a financial surveillance network
• Requiring centralized crypto-exchanges to track the addresses of all the outflows from the exchanges and then subsequently tracking the activities of the addresses
• Outright banning cryptocurrencies from being used
• Enforcing all merchants accepting cryptocurrencies to track the identity of the customer and reporting to the taxing authorities periodically
• Imposing an additional “crypto sales tax” for cryptocurrency payments

And some liberal approaches could include:

• Removing taxes for cryptocurrency trades and payments
• Imposing only income taxes for cryptocurrencies (for those earning income in cryptocurrencies) and collecting the taxes in the type of the cryptocurrency selected by the taxpayer
• Having a maximum capital gains threshold where only transactions resulting in significant capital gains are taxed

The authoritative approaches seem almost dystopian and the liberal approaches seem too good to be true. Reality will probably (and hopefully) be somewhere in the middle.

Although we are still in infancy, cryptocurrencies are beginning to take off and the tax authorities will have to catch up with regulations that make sense before being left behind. From Elon Musk, to the Fed Chair, and to the Chinese government, more and more people seem to be thinking about the implications of cryptocurrencies. Cryptocurrencies are disrupting the conventional infrastructures and the regulations built for legacy models may not work anymore. Will the authorities try to keep the legacy models through enforcement? Or will they have no choice but to adapt? Will the concept of taxes be completely changed due to cryptocurrencies? Or will cryptocurrencies be only an investment play forever? All speculative questions for now but the disruption may hit sooner than we expect.