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Tax Law

A Cryptocurrency Conundrum

Adjunct Professor Richard Ainsworth tackles regulation of the notoriously opaque sector.

As Congress and others debate how to regulate the notoriously opaque cryptocurrency sector, Boston University School of Law Adjunct Professor Richard Ainsworth offers a deceptively simple proposal—collect a tax on each cryptocurrency transaction and dedicate the proceeds to help fight global problems such as the COVID-19 pandemic.

Cryptocurrency—a digital currency secured by anonymous lines of computer code—once appealed mainly to tech-savvy investors and those trying to shield their activities from law enforcement. But as crypto investing goes mainstream—with the market growing to an estimated $2 billion—federal regulators have begun eyeing ways to protect consumers and crack down on tax evasion. 

This summer, lawmakers took the first step toward regulation by proposing new tax-reporting requirements for cryptocurrency transactions as part of the $1 trillion infrastructure bill. Unlike stockbrokers, cryptocurrency brokers don’t have to report investor gains and losses to the IRS, making it easier for people to cheat the tax system.

SEC Chairman Gary Gensler has signaled a desire to regulate an industry he calls “rife with fraud, scams, and abuse.” Testifying before the Senate Banking Committee in September, Gensler argues that regulation will strengthen the crypto industry. “I think that this technology has been and can continue to be a catalyst for change, but technologies don’t last long if they stay outside of the regulatory framework.”

Ainsworth’s proposal aims to thread the needle between regulating the industry without squashing innovation.

“This research is one example of how the tax program is at the forefront of important conversations about the taxation and regulation of digital currency,” says Christina R. Rice, director of BU Law’s Graduate Tax Program.

One of the most significant challenges regulators face is imposing new rules without destroying the cryptocurrency market, Ainsworth says.

In a scholarly paper published in Tax Notes International last year with New York University School of Law student Xiuyuan (Tony) Hu, Ainsworth argues that any taxing system needs to preserve the anonymity of transactions. This feature draws cryptocurrency users to digital exchange platforms in the first place. Users will go elsewhere, carrying on with their criminal enterprises and leaving the tax authorities high and dry.

“These guys will melt away faster than a snowball in the summertime,” he says of the tech-savvy cryptocurrency set.

Imposing a flat tax on each transaction is not a perfect solution. For example, it doesn’t solve the problem of people exploiting the privacy that cryptocurrency provides for nefarious purposes such as funding terrorism and dealing drugs. And it doesn’t tax individuals based on the profits they receive from crypto investments. That means that crypto speculators could continue to accumulate capital gains that are not reported to the IRS.

But, Ainsworth says, it’s a good first step toward getting a handle on the emerging digital currency market, which has proven difficult for law enforcement to penetrate. A study by three researchers in Australia—Sean Foley, Jonathan R. Karlsen, and Tālis J. Putniņš—who estimated that as of August 2017 “at least 27 million bitcoin market participants were using the cryptocurrency primarily for illegal purposes to conduct some 37 million transactions each year.”

His proposal doesn’t target the criminals but takes a more manageable path by collecting taxes from the companies running the exchanges that allow people to trade in the market. These platforms have an incentive to follow the law so they can market themselves to the public as legitimate places to do business.

“We’re not trying to stop crime,” Ainsworth says of his proposal. “We’re trying to collect an honest amount of revenue. In a sense, we’ve been subsidizing these operations by giving them a tax-free way of conducting criminal activity.”

It may not seem fair to tax both legitimate and illegitimate transactions at the same rate. Still, Ainsworth argues that many consumers would be willing to pay a premium for the financial privacy that digital currency provides. Governments could also devise tax credits or rebates for law-abiding consumers.

The money raised by the tax would then be distributed based on need—for example, to distribute vaccines, provide humanitarian assistance to hard-hit jurisdictions, or help the world prepare for the next pandemic.

Ideally, a global body such as the United Nations would administer the funds. Ainsworth concedes this would require “strong international cooperation and political will.”

One of the other major challenges in regulating crypto exchanges in the US is determining which agency is responsible. The Securities and Exchange Commission, the Treasury Department, and the Internal Revenue Service could conceivably be involved, Ainsworth says. The Consumer Financial Protection Bureau is also positioning to take the lead on enforcement in response to a sharp increase in consumer complaints about cryptocurrencies.

If regulation takes the form of a tax, as Ainsworth proposes, other countries would also need to agree to the taxing scheme to prevent people and companies from moving their accounts offshore.

The idea for taxing crypto transactions arose during Ainsworth’s Tax Fraud and Technology class, where students explore how people are cheating the system using technology and how to prevent that fraud.

“It’s a good melting pot,” he says. “If you ask good questions to good students, you get new ideas.”

It remains to be seen whether the idea will gain any traction in the regulatory arena. “This is a very contemporary idea. It’s marketable because it’s easy to explain, and it’s highly creative,” Ainsworth says. “I don’t see anybody else proposing something like this.”