Governments cannot watch such transactions become part of the underground economy
The extraordinary rise in the value of Bitcoin and other cryptocurrencies has led many people to worry that this market is a giant bubble. Many, including the US Federal Reserve chairwoman Janet Yellen and the billionaire investor Warren Buffett, have warned about a “Bitcoin bust” that could rival the dot-com crash of 2000 and wipe out speculators.
But the bigger concern about cryptocurrencies may be the damage they could do, in the long run, to government finances through lost tax revenue. The core technology underlying cryptocurrencies, known as blockchain, is premised on anonymity: Transactions are public but linked only to an electronic address. This is a big part of what makes blockchain attractive.
But anonymity is also the main fuel for the underground economy, which is now conducted largely via cash. The underground economy is a significant source of lost tax revenue. The US Internal Revenue Service estimates that it loses around $500 billion annually because of unreported wages alone.
And the underground economy in the US — estimated at 8.4 per cent of output — is relatively small compared with those of other countries. If cryptocurrencies were to replace cash as the preferred anonymous medium of exchange, they could significantly expand the underground economy because they are so much more convenient than cash.
There is no need to visit an ATM, and you can securely pay people regardless of their location. No wonder Steven Mnuchin, the US Treasury secretary, expressed concerns recently that Bitcoin could become “the next Swiss bank account”.
The IRS. understands this, which is why it has been pushing to break the anonymity of cryptocurrencies. In November, it persuaded a federal judge to order Coinbase, a popular Bitcoin exchange, to reveal the identity of the customers for more than 14,000 accounts (representing nearly nine million transactions).
Blockchain technologies can also make it difficult for the IRS to tax cryptocurrency trading profits. Here is a simple tax dodge that would be hard for the IRS to prove: Suppose A, B and C are electronic addresses you own. You let the IRS know you own A, but not B and C. You buy one Bitcoin at $15,000 and park it at A, expecting the price to go up.
Just a few hours later, when a Bitcoin is worth $15,500, you send that Bitcoin to B and then to C.
A few months later, when your Bitcoin is now worth $25,000, you send it from C to A and tell the IRS, “I sold a Bitcoin to an anonymous counterparty at B back at $15,500 and just now bought a Bitcoin from another anonymous counterparty at C for $25,000.”
As a result, you owe taxes on capital gains of just $500 rather than $10,000.
The IRS can observe all the transactions between A, B and C on the Bitcoin blockchain, but it cannot disprove that B and C are “arm’s length” counterparties (that is, independent and not colluding). Rules in the US that require financial institutions to verify the identity of address holders do not solve the problem, because as far as the IRS knows, B and C could have been set up by a foreign institution that does not comply with such rules.
It is inconceivable that the government would simply accept enormous revenue losses from a larger underground economy and from tax dodges on trading profits. The only question is how heavy-handed the response would be.