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The following article is an exclusive contribution to CoinDesk's Crypto and Taxes 2018 series.
Bitcoin has a remarkable way of teaching people very rapidly about the law of unintended consequences.
A great example is when the Chinese government began inspecting regulated exchanges in February 2017. Believing that the exchanges might get shut down (they eventually did), buyers flocked to Localbitcoins, a peer-to-peer exchange whose volume surged 3,600% in the course of a month. By trying to keep better track of and control bitcoin users in China, the government drove them to a method that was much harder to surveil.
In the U.S., the Internal Revenue Service's (IRS) treatment of bitcoin taxation has arguably had a similar effect.
By effectively telling taxpayers they need to calculate capital gains taxes for every $25 gift card purchased with bitcoin, the IRS is giving them one more reason to treat bitcoin less like a payment protocol and more like digital gold.
But perhaps more importantly from a public-policy perspective, the agency's guidance may encourage citizens to use unregulated foreign cryptocurrency exchanges and transact using privacy coins such as zcash and monero. It's almost certainly a contributing factor behind the estimated 0.5% self-reporting rate among bitcoin users come tax time.
The vast majority of bitcoin users I know understand that paying taxes on short- and long-term capital gains is not only required by law, but also fair. The same cannot be said for the taxing of purchases of low-dollar items under the guidance that the IRS issued four years ago.
The 2014 guidance
Stepping back, when that guidance came out in March 2014, the market looked very different.
It had been less than a month since Mt Gox ceased all withdrawals, and a teenage Vitalik Buterin had just introduced a "client that looks like Android that can run apps" called ethereum.
I was at Coinsummit 2014 the week the IRS published its guidance stating that digital currency would be treated as property, even if it was being used to buy baseball caps or MP3s.
At the conference, I asked Vinny Lingham, then CEO of Gyft.com, what support his company might offer for customers who had purchased gift cards with bitcoin on his platform over the past year.
His answer was that while Gyft could make it easier to track spending, it would be unable to verify the cost basis of any bitcoin used to make purchases.
As a result, all purchasers of these gift cards would either: 1) manually track all their purchases, sales, gains, losses, and transfers 2) stop using bitcoin to purchase gift cards or 3) become white collar criminals who don't report a portion of their taxes.
I don't think it's a mere coincidence that 2014 was the year the bitcoin community started to bifurcate between those who invested in it as store of value and those who used it as a currency to make purchases. This division only grew sharper in the years, and led last year to the fork in protocols of bitcoin and bitcoin cash.
To be sure, there were many factors behind the split: from the differing incentives between startups and other factions of the community to bitcoin's deflationary nature and rapid price appreciation.
But by ignoring the consumer-usage angle and focusing solely on investing and speculating, the IRS further incentivized HODLing and discouraged everyday purchases with digital currency.
Bitcoin's track record as a speculative investment has not disappointed, either, with the value of bitcoin up 2,000 percent since the IRS first released its guidance, while daily transactions (an admittedly unscientific measure of bitcoin's use as a payment method) have merely doubled.
In the IRS' own interest
As an agency narrowly focused on maximizing revenue, the IRS is probably indifferent to the way people choose to use bitcoin, so long as gains are reported and taxes paid.
But by discouraging the real-world use of cryptocurrencies as money for purchasing goods, the IRS is reducing the incentive for companies in the space to build robust tools to track spending and improve tax reporting.
There might be a straightforward way for the IRS to mitigate these consequences, though.
A year ago, Coin Center, a non-profit research and advocacy center focused on the public policy issues facing cryptocurrency technologies, published a piece entitled "Bitcoin taxation is broken. Here's how to fix it."
In this post, Executive Director Jerry Brito argued that when bitcoin or other cryptocurrencies are used to purchase goods such as coffee or socks, they are being used not as investments, but similar to the way in which foreign currencies are used by Americans to purchase goods abroad.
Brito went on:
"Say you buy 100 euros for 100 dollars because you're spending the week in France. Before you get to France, the exchange rate of the Euro rises so that the €100 you bought are now worth $105. When you buy a baguette with your euros, you experience a gain, but the tax code has a de minimis exemption for personal foreign currency transactions, so you don't have to report this gain on your taxes."
By implementing a similar de minimus exemption for cryptocurrency gains under $200, the IRS could massively simplify the tax code in this area and make it more likely that bitcoin users will report their gains properly. These ideas are not entirely dissimilar from ones I proposed in a 2014 paper on the same subject.
Not only would this spare bitcoiners from having to keep records of every piddling purchase they make or live in fear of prosecution, it might also improve overall tax compliance. How's that for counterintuitive results?
Losing control image via Shutterstock.