Cryptocurrency Tax Conundrum: Striking a Balance Between Compliance and Policy

Despite cryptocurrency's upward revenue trajectory and the promise of decentralized finance, it presents challenges to tax compliance and policymaking, leading to significant revenue loss. Existing policies and enforcement of untaxed crypto transactions can effectively address these challenges, while whistleblower programs and artificial intelligence have proven successful in targeting crypto tax evaders. Reforms to enhance the efficacy of these programs, rather than revolutionary taxation methods, can help mitigate the societal costs and capture lost tax revenues.

The Crypto Conundrum: Tax Compliance and Policy Challenges in the Digital Asset Era

The cryptocurrency market has surged with remarkable momentum, captivating investors and disrupting traditional financial systems. However, amidst this exponential growth, a formidable challenge emerges: ensuring tax compliance and devising sound policy frameworks in a landscape that has yet to fully mature.

The Tax Reporting Gap: A Hidden Liability

As digital assets gain widespread adoption, the tax reporting gap has widened considerably, resulting in an estimated $50 billion in lost revenue from untaxed crypto transactions. This discrepancy has ignited concerns, prompting policymakers and tax authorities to seek innovative solutions to bridge the gap.

The traditional approach of tax enforcement, relying solely on individual compliance, has proven insufficient to effectively address the unique complexities of cryptocurrencies. The inherent anonymity and decentralized nature of these assets render them susceptible to tax evasion and avoidance.

Enhancing Enforcement: A Call for Pragmatism

In addressing this challenge, the reconsideration of existing policies, rather than the pursuit of revolutionary tax schemes, may prove more effective. Enhancing the capabilities of established programs, such as the IRS whistleblower program, offers a promising approach.

The IRS whistleblower program has been instrumental in combating traditional tax evasion and corporate non-compliance. Since its inception in 2006, the program has distributed over $1 billion in awards, facilitating the recovery of more than $6 billion in tax revenue.

However, the program is not without its limitations. Reforms aimed at improving its efficacy, including the imposition of interest on delayed awards and the elimination of budget sequestration effects, would significantly enhance its impact.

Harnessing Technology: AI in the Fight Against Tax Evasion

The advent of artificial intelligence (AI) presents both challenges and opportunities in the pursuit of tax compliance. While tax evaders may leverage AI to conceal their activities, whistleblowers can harness its capabilities to uncover hidden transactions.

Government agencies partnering with entities that specialize in de-anonymizing cryptocurrencies have demonstrated success in identifying tax evaders. Chainalysis, a blockchain analysis firm, played a pivotal role in the takedown of the Silk Road dark web exchange.

AI's ability to sift through vast amounts of transaction data allows for the identification of patterns and red flags that indicate non-compliance. This technology can automate the process of filing whistleblower reports, further streamlining the process.

Expanding whistleblower programs to target crypto transactions and offering substantial rewards for information leading to the identification of tax evaders could incentivize platforms to actively combat cheating.

Administrative Workability: The Importance of Simplicity

The unique characteristics of cryptocurrencies, such as anonymity and energy consumption, may tempt policymakers to pursue complex and technologically advanced tax policies. However, the implementation and enforcement of such policies often face obstacles.

Proposals such as applying the wash sale rule to digital currencies and imposing an excise tax on digital asset mining could prove impractical and difficult to administer. Determining substantial identity among the thousands of cryptocurrencies in existence would be a tax policy challenge in itself.

Furthermore, the excise tax on electricity used for mining raises questions about its fairness, given the difficulty in distinguishing mining-related electricity usage from other forms of power consumption.

No Revolutions Required: Rethinking Existing Approaches

Addressing the tax challenges posed by cryptocurrencies does not necessitate revolutionary new approaches. Recalibrating existing policies and programs to effectively target new activities can yield significant results.

Transactions involving cryptocurrencies typically involve multiple entities with knowledge of the parties involved. While individuals may not know each other's identities directly, they are often incentivized to ascertain them. Cryptocurrency exchanges, due to know your customer (KYC) and anti-money laundering (AML) regulations, possess the identity of at least one party to the transaction.

The key lies in incentivizing parties to ensure tax compliance. Offering attractive incentives, such as whistleblower reforms, could encourage cooperation and reporting.

Conclusion: Striking a Balance

Navigating the tax challenges posed by cryptocurrencies requires a balanced approach that leverages existing infrastructure while embracing technological advancements. By enhancing existing programs, harnessing AI, and implementing pragmatic policies, tax authorities can effectively safeguard revenue and promote tax equity in the digital asset era.

About the Author

Andrew Leahey is a tax and technology attorney, principal at Hunter Creek Consulting, and adjunct professor at Drexel Kline School of Law.