The Bitcoin Regulatory Paradox

The ways in which Bitcoin could innovate the e-commerce and m-commerce sectors is not a new conversation. Mondato Insight has considered the benefits of Bitcoin in the past (see here and here) in relation to financial inclusion and international remittances, and others have detailed how Bitcoin is affecting the electronic commerce space. But with the rumbling of legislative bodies and experimental laws underway, one can’t help but wonder: will this strengthen Bitcoin as a form of payment or banish it to the shadows?

The relationship between Bitcoin and regulation is inherently paradoxical. Enthusiasts committed to the Bitcoin revolution often cite decentralization, low-transaction fees, and a public ledger (the “blockchain”) that obviates double-spending albeit maintains anonymity as some of Bitcoin’s most enticing offerings. The introduction of regulation signals, however, an intellectual depreciation of these envisioned benefits of Bitcoin.

For the causal effect of regulation and intellectual value depreciation to hold true, Bitcoin society must interact within itself on the premise that value is derived purely from its exchange for goods and services. This assumption is hardly universally accepted by commentators that have attempted to dissect the internal workings and money flow of Bitcoin. Instead, many experts have recorded the development of Bitcoin as a tool of investment and speculation – and the feedback effect between legislation and hoarding may have wider repercussions for the future of Bitcoin as a payment.

The Hoarding Paradigm

Hoarding is considered to be a fundamental threat to the goods and services paradigm. With a fixed number of Bitcoins ever available for circulation, speculators are not incentivized to make purchases but rather to retain the Bitcoins until a spike in price. Concerns regarding the liquidity of the Bitcoin market were echoed by Venture Capitalist Fred Wilson in his speech to an NYU audience in July 2014. A statistic estimated that upwards of 70 percent of Bitcoin had remained inactive in the 6 months prior to November 2014. Even the behavior of Bitcoin companies has compounded the effects of hoarding.

Although the hoarding of Bitcoin is a documented phenomenon, not all cryptocurrency experts or economists agree on its enduring consequences for the survival of Bitcoin. Those that identify with a more pessimistic camp have forecasted an inevitable crash as the network, and currency, become useless. Others emphasize its nature as a conduit– it is essentially another way to enact transactions in fiat currency, therefore sheltering it from a deflation spiral.

The paradigm that the Bitcoin community ultimately settles upon, however, could have remarkably different consequences as to whether legislation is categorized as friend or foe, or with more nuance, lesser-evil or evil.

The Introduction of Tax Regulation

In the United States, the tax differential between a capital investment and currency is no ignorable sum. If Bitcoin is classified as a capital asset, long-term gains and losses would be subject to a 23.8 percent tax rate for those in a high-income tax bracket, and losses of US$3,000 or more could offset other gains.

In contrast, if Bitcoin is classified as a currency, the rate of taxation from profits of sales would be capped at 39.6 percent but losses could negate other income. And how are these classifications derived exactly? In November 2013, Mindi Lowy and Miriam Abraham of PriceWaterhouseCoopers postulated that the virtual currency would most likely be deemed as a capital asset due to the limited use of Bitcoin. If merchant acceptance and the volume of consumer transactions climbed however, regulators would be more poised to define it as a currency.

When the IRS did release tax guidance on virtual currencies in March 2014, it was designated a property, not a currency. The preferential taxation rate for capital assets was implemented.

Unfortunately, the IRS tax interpretation of Bitcoin as an investment has not only fed into the hoarder rationale, but may even solidify it. As there is no way for consumers to differentiate their Bitcoin wallets as capital or non-capital, individuals that primarily utilize Bitcoin for the consumption of goods and services could be penalized. The capital gains tax, especially for long-term holders of Bitcoin that have enjoyed 10 to 100 fold increases in value, could constitute large percentages of a transaction. The absence of an equivalent de minimis law, which dictates that gains and losses under US$200 while trading to and from foreign currencies are not taxable, may add a deterrent to widespread adoption of Bitcoin for consumer purposes.

For those, though, that await to see the backbone of Bitcoin evolve into a consumer network, there is hope. The choices of the American IRS do not necessarily reflect or inspire the entirety of the global trend. The regulation regime of Germany is friendlier to the individual that engages in the trade of goods and services.  Germany has declared Bitcoin as an asset of private money. Coupled with this declaration is the legislative maneuvering which legally exempts Bitcoin from VAT in transactions. However, this does not exclude individuals from income tax. In Germany, if a profit is generated by the exchange of Bitcoins (whether to currency, cyrptocurrency or goods and services), it is subject to income taxation. A taxation exception exists for an exchange of cryptocoins if the profit from the trade is less than 600 Euros, or the individual has been in possession of the Bitcoin for a period longer than one year. This allows for a consumer culture within Bitcoin to develop without the levying of heavy taxes.

As a final caveat, the above tax laws are only considered in the context of the individual. How governments choose to impose taxation or licensing upon corporations that decide to buy and sell Bitcoins may have a whole different set of ramifications. Or perhaps the most tentative deadly blow is how governments choose to impose taxation upon the income of individual or groups of miners, as the profitability window for ‘mining’ is already dwindling.

Consequences

In theory, all legislation that endeavors to tax the trades or capital gains of Bitcoin would have a depressive effect on its popularity and price. However, due to the global reach of Bitcoin, the plurality of regulation imposed on its patrons, and the nascent or pending state of legislation, it is almost impossible to definitively analyze the effect of a legislative shock on Bitcoin (at least today in 2015).

Clearly the paradox between legislation and decentralization, and the following intellectual depreciation, is rooted in reality. The reclassification of Bitcoin from vouchers (the VAT for vouchers is 20 percent) to assets or private money by the HMRC in the United Kingdom was at least partially the product of proactive lobbying by those affiliated with Bitcoin in London. While it is too early for empirical data to measure the effect of legislation on Bitcoin, one can say that cumbersome taxation rules (or high rates against day to day transactions) would act as a strong disincentive for those contemplating an entrance to the Bitcoin market for consumer purposes.

The relationship between Bitcoin as an investment and regulation is more complicated. Many investors herald the advent of Bitcoin and its accompanying technology, specifically the blockchain, as rivaled only by the invention of the internet. In environments like the United States, the lower capital gains taxation rate would unlikely spur a meaningful exodus from the market, especially since regulation is considered a tradeoff- taxation versus consumer protection via loss offsets. In environments that are conditional to the higher income tax rates, more cautious speculators or those less convinced with the longevity of Bitcoin could be driven to divest their money.

It seems though, for the average investor, his / her faith in Bitcoin transcends the fear of taxation or losses. This, in itself, could also be good news for the goods and services paradigm. It could prevent a major flight from Bitcoin while legislative bodies address the inversely related high income tax / lower transaction cost or lower capital gain taxes / higher transaction cost structures. The rectification of this structural dissonance would help create a stable duality of use for Bitcoin.

However, for that scenario to culminate, advocates of the goods and services paradigm must be pro-active and educated participants in the legislative process. If Bitcoin is ever to come to fruition in the e-commerce or m-commerce sectors, it must not be pigeon-holed in its applicability by legislation. This can be remedied by a Bitcoin consumer society that is not only cognizant of legislation and its effects vis-à-vis hoarding or trading, but by lobbying and exerting pressure on legislative bodies to ensure that the growth of Bitcoin is not stunted by limiting policies.

©Mondato 2015. Mondato is a boutique management consultancy specializing in strategic, commercial and operational support for the Mobile Finance and Commerce (MFC) industry. With an unparalleled team of dedicated MFC professionals and a global network of industry contacts, Mondato has the depth of experience to provide high-impact, hands-on support for clients across the MFC ecosystem, including service providers, banks, telcos, technology firms, merchants and investors. Our weekly newsletters are the go-to source of news and analysis in the MFC industry.

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