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Introduction

When Bitcoin launched in 2008, cryptocurrency enthusiasts viewed it as a major disruptor of government power because it provided an alternative to government-controlled currency.[1] To those who view government largely as an encumbrance, this new technology promised to bypass centralized and hierarchical political institutions using distributed consensus, laying the foundation for an idealistic society of equals.[2]

The act of decentralizing away from the state is often associated with an increase in personal freedom from the power of the collective.[3] The argument put forward by early cryptocurrency enthusiasts was that personal freedom would be increased if individuals were given full use of their own economic resources, free of any form of coercive taxation towards collective purposes.[4] But some of the core design elements of cryptocurrencies demonstrate that all communities—even virtual ones—inevitably find it necessary to pool resources to produce goods used by all. Even in the world of cryptography, the sphere of personal freedom over one’s own resources is limited by the need to sustain the community in which one operates.

An inspection of the fiscal design of popular cryptocurrencies demonstrates that their founders inevitably develop a core set of governance goods, comparable to public goods developed by states. These goods are infrastructural in nature and essential to the functioning and value of the cryptocurrency. Like governments, cryptocurrency founders must make their foundational infrastructure reliable so that investors and users will continuously contribute to and benefit from the collective value of the community they thereby create. In concrete terms, this means that the founders need to figure out a way to finance the necessary human resources and capital investments to maintain the cryptocurrency over the long term, using resources contributed or generated by developers, miners, investors, and users.

The act of creating a self-sustaining financial structure for a cryptocurrency system looks similar to the act of creating a tax system in several respects. First, creating such a structure obliges the founders to choose how to distribute all currently foreseeable infrastructure costs as well as the potential risks of unknown future costs amongst the various identified stakeholders of the system. The task of identifying such stakeholders is itself a choice similar to what lawmakers face in determining who should be considered a taxpayer. Founders necessarily make these identification and distributional choices with a view not only to providing cryptocurrency holders and users with a given service, just as a business making supply chain cost and quality decisions might do, but also to ensuring the ongoing viability of the underlying structure itself. Further, making these policy choices has economic impacts on individual users and on the system as a whole, akin to the micro- and macro-economic effects of fiscal policy choices within states.

While the founders of cryptocurrencies may not conceptualize their efforts as such, these kinds of infrastructural choices mimic those routinely made by governments in the design of fiscal policy. The intrinsic purpose of fiscal policy is to distribute burdens and benefits among a given populace in order to achieve common goals.[5] In making private order fiscal policy choices, cryptocurrency founders thus confront both individual and system-wide risks and impacts. The totality of their decision making in this regard constitutes essential elements of “taxation” written into the governance structure of the cryptocurrency system—its tax cryptographia.[6]

As a representation of the fiscal policy choices of its founders, the tax cryptographia of a given cryptocurrency system demonstrates that embedding some mechanism for resource pooling and spending is unavoidable. The emergence of a function that parallels state-based taxation in an endeavour expressly designed (to some, at least) to escape the state and its ubiquitous taxing power is intrinsically fascinating. More fundamentally, the inevitability of tax cryptographia offers an opportunity to re-examine why it is that taxation is a fundamentally necessary aspect of any cooperative socio-economic order, even when the underlying rationale in the cryptocurrency sphere is to eliminate the state.

Accordingly, this article examines how cryptocurrency founders determine what basic goods are necessary to make their systems viable and then design a way to fund them. The object is to examine how investors, speculators, enthusiasts, and skeptics should assess the decisions that founders make, and why it might matter if the participants in cryptocurrency systems recognize the fiscal infrastructure as a reproduction of state-like functions that allocate the costs and benefits of participating in the collective activity.

Part I undertakes a brief background of cryptocurrency systems, with a particular focus on their main fiscal elements. Part II analyzes why and how these fiscal elements might be considered a form of, or at least comparable in fundamental ways to, taxation. Part III assesses the choices made by cryptocurrency founders to date and queries how they ought to be assessed. The article concludes that despite the ideological roots of today’s cryptocurrencies, it is not possible to design any kind of cooperative social order without fiscal policy. Whether cryptocurrency founders will learn any lessons from the history of taxation is another question.

I. Background: Fiscal Infrastructure Elements

A thorough explanation of the technological innovation behind cryptocurrency is beyond the scope of the current discussion and readily available elsewhere,[7] but a simplified explanation of the general idea of decentralized ledger technology is useful in considering the theory presented in this paper, namely that cryptocurrency founders and developers are engaged in making fiscal choices that mimic taxation and state-building in fundamentally important ways. If this assessment is correct, it tells us something about the nature of cooperative market-making without the state, namely, that effective cooperation cannot be accomplished without coercively allocating costs and benefits among participants, and that therefore making sound fiscal choices should be viewed as imperative to designing a viable cryptocurrency. This Part provides a brief overview of various aspects of decentralized ledger-based cryptographic protocol design and maintenance relevant to resource allocation questions, examining the fiscal features of cryptocurrency systems and contextualizing the discussion within the language of taxation.

A. The Infrastructural Core: Decentralized ledger technology

In general, cryptocurrencies modeled after Bitcoin are digital assets produced and traded via a decentralized database that is maintained by a distributed network of computers. Participating computers iteratively record (in “blocks”) the history of all the transactions on the network, thus the database is decentralized in the sense that each node stores up-to-date copies of the ledger, thus collectively ensuring the validity of each transaction.[8] Participants who want information added to the blockchain, for example regarding a transfer of an amount of cryptocurrency from one participant’s digital wallet to another, must apply to have their transfer recognized by block producers (“miners”) who generally receive rewards for their maintenance of the system and for verifying transactions in the form of newly issued cryptocurrency or tokens, in addition to transaction fees provided in respect of each transaction.[9]

In the Bitcoin blockchain, miners initially received fifty Bitcoin for mining a new block. The Bitcoin protocol provided for the reward to be halved every 210,000 blocks, which is approximately every four years.[10] At the time of writing, the reward is twelve and a half Bitcoin per new block.[11]

The compensation of miners can be characterized as a fiscal design choice in the sense that it is a systemic and unavoidable cost added to all private transactions, it is undertaken for communitarian reasons, and it has distributional economic impact. The cost to compensate the essential block production, which is collectively a blockchain maintenance function, may be characterized as quasi-private (transaction fees) or quasi-public (block rewards) in nature, as described below.

B. Block Production Reward Design

The security, certainty, and decentralization of cryptocurrency systems do not occur as natural features but require time and resource investment. In particular, cryptocurrencies depend on constant updating in the form of block production. Block production rewards may be viewed as a quasi-public component of cryptocurrency fiscal design because they are paid out by issuing new tokens—that is, printing money. The issuance of new currency alters the outstanding supply and therefore affects all those in the network, whether they are actively transacting in the currency or not.

The amount of rewards paid to block producers may change over time either by predetermined schedule, as described above in the case of Bitcoin, or by community consensus. For example, Ethereum rewards are periodically set at a specified number per block according to analysis and consensus of the mining community.[12]

Accordingly, with each block produced, wealth is effectively transferred from all existing token holders to the block producers in the form of inflation. The extent of the inflation produced by rewarding miners might be relatively modest. In the case of Bitcoin, for example, the estimate is currently 3.7 per cent per year, which is expected to drop to 1.8 per cent per year after the next reward-halving event occurs.[13] For non-finite cryptocurrency models, it is harder to determine the effect of new currency issuance for block production. Miners may be expected to trade on their relative sophistication regarding expected inflationary profits.[14]

Where the available amount of the cryptocurrency to be produced is finite, as it is in the case of Bitcoin, the system is designed to be non-inflationary on the long run.[15] When the last token is mined in such a system (as Bitcoin will be at twenty-one million), block production rewards will end. At that time, it is assumed that transaction fees will be the sole method of rewarding block production.[16] For other systems, transaction fees may be more or less important depending on the control of miners over the amount of block production awards.

C. Transaction Fee Design

Because they are paid by users for a specified service, mining transaction fees might be viewed as the private component of fiscal design in cryptocurrency systems. Even so, these fees have unexpected quasi-public features and impacts. A transaction fee may be comparable to a user fee since each participant wanting data recorded and validated must pay for the service.[17] But unlike a club charging entry fees or a state charging for toll roads or the like, the maximum amount of a transaction fee is not necessarily predetermined or predictable, and the impact of the fee payment is not limited to the person paying it.

In the Bitcoin model for example, the software sets minimum fees and participants may choose to pay miners more than the minimum required amount. These decisions are made individually, by reference to what the participant expects miners to be willing to accept in filling their next block with data, but a minimum amount may be designated by the miners.[18] A lower amount will almost certainly result in a delay in processing, perhaps for months. A higher amount will ensure miners’ attention and be included in multiple block production such that transactions will be more likely to be verified as the blockchain lengthens.

Given the additive nature of block production, transaction fees are distinguishable from standard user fees because they have systemwide impact. That is, even though transaction fees are typically paid only to successful miners and therefore validate only those transactions associated with the fee-payors, the overall cost of processing transactions ultimately spreads throughout the cryptocurrency network as all validators incorporate the information and subsequent blocks carry validated transactions forward in time.[19]

D. System Sustainability

Together, the fee and reward system constitute a fiscal structure that is essential to the development of a successful cryptocurrency. In particular, mining must be profitable in fiat currency terms because mining requires investing in goods that can typically only be paid for in fiat currency—namely computers, the energy to run them, and the facilities to house them.[20] The profitability of mining depends on whether the tokens received as rewards and fees are either freely transferrable into sufficient amounts of fiat currency to cover costs and generate a profit, or directly accepted by energy companies as payment, while leaving sufficient residual to compensate the miner.

Accordingly, the viability of a blockchain-based currency system depends upon (1) the founders generating sufficient interest in the currency such that the market price exceeds the maintenance or continuation cost[21] and (2) the cryptocurrency being freely tradeable into fiat currency, at least until vendors of computers, electricity, and facilities, as well as taxing and other fee-imposing authorities accept cryptocurrency instead of fiat currency in exchange.[22] So long as these conditions are fulfilled, miners will continuously invest fiat money to mine blocks in exchange for cryptocurrency rewards.

Since block producers must receive rewards and fees in order to maintain the value of the overall network, every cryptocurrency system must necessarily introduce a system of wealth transfer to meet their expectations. The fiscal choices made to effectuate such transfers is, in effect, the internal tax system of blockchain—that is, its tax cryptographia.

Like the larger lex cryptographia of which it constitutes an essential element, tax cryptographia is built in to a particular cryptocurrency system via coding and protocol updates but it is subject to perpetual renegotiation by the participants.[23] The same definition could be applied to taxation by the state: written into codes, taxation rules are so important to the economic and social functioning of societies, and so impactful on the lives of individuals subjected to them, they become permanent features of the political landscape everywhere they are imposed.[24] Accordingly, the next section undertakes an explicit comparison of tax cryptographia to state-based taxation.

II. Blockchain’s Fiscal Logic: Is It Taxation?

This Part examines why the fiscal structure of cryptocurrencies might be analyzed as a form of taxation. This characterization is significant in governance terms precisely because cryptocurrencies are so often promoted as permitting their participants to break free from the coercive power of the state. If cryptocurrency developers effectively recreate state-like conditions for their participants by redistributing participants’ wealth to fund goods of value to all, then the same political struggles that attend to state governance efforts, especially taxation, arise in the context of cryptocurrencies.[25] Because miner compensation is an essential element of every cryptocurrency, and because the act of mining produces what amounts to a quasi-public good internal to the particular cryptocurrency, this Part concludes that cryptocurrency founders are inescapably in the business of recreating what amounts to taxation systems, with attendant policy ramifications.

A. Mining is Obligatory

As outlined above, in designing a cryptocurrency, incentivizing block production is a threshold consideration because if mining is not profitable, transactions in the currency will not be recorded, trading will stop, the value of the currency will plummet, and the cryptocurrency system as a whole will fail.[26] May transaction fees and block production rewards thus be seen to take on tax-like functions in the blockchain space? The voluntary nature of participation in a given cryptocurrency might suggest not, since taxation is typically defined as the compulsory transfer of resources among members of society.[27] Yet cryptocurrency founders must violate the economic freedom of participants to some extent to ensure miners will be amply rewarded for their infrastructural contributions. Like conventional legal orders, cryptocurrency systems inevitably appropriate to common purposes specified property that would otherwise accrue to private ownership. Conventional taxation does so through constitutions and laws, whereas cryptocurrency taxation does so with computer code.

Clearly the coercive power of the state to control human movement in and out of the system it creates is relevant and makes cryptocurrency fiscal design a fundamentally different project than state-level governance. It is relatively easy to buy into and out of one cryptocurrency or another, while physical borders backed by police and military powers more forcibly restrict a person from moving between autonomous sovereign territories. Still, there are important parallels. The extraction of resources from some to pay others is not voluntary within a cryptocurrency system in the same way that it might be in another market exchange environment. This is because the costs to users are not borne as service fees to a specific entity such as a business but as part of the total environment. Further, the benefits of transaction validation are not confined to those engaging in specified transactions but are system-wide.

As such, there are some strong similarities between what cryptocurrency founders are doing in incentivizing block production, and what states do when they are organizing themselves.[28] States typically have to find a means to establish control over a physical territory and a people.[29] They use taxes (although not necessarily exclusively) to pay individuals to govern as legislators, judges, and law enforcers, to build government buildings and related infrastructure, and to wage war against other societies, whether in aggression (to gain territory or resources) or to defend against aggression from other societies.[30]

Similarly, although cryptocurrency founders need not defend a physical territory, they clearly must establish a digital territory and then defend it against attacks. When they fail to do so in the eyes of enough of their participants, they will face social fracture, such as Ethereum did in a highly publicised event in 2016.[31] It is therefore probably uncontroversial to conclude that cryptocurrency founders, before doing anything else, must find a way to incentivize mining of their token. It might be more controversial to suggest that this activity amounts to anything more than a set of private market transactions, but there are reasons to conclude that, in fact, mining effectively produces something like public goods within the system it helps to build.

B. Mining Produces a Quasi-Public Good

Cryptocurrency mining is clearly undertaken for private gain, but there is an altruistic outcome to the collective effort of miners, namely, the maintenance and value enhancement of the blockchain as a whole. This makes mining comparable to the government function of providing public goods, such as physical infrastructure and defence.[32] The question is whether the comparison is apt and if so, what the standard cryptocurrency mining compensation structure might tell us about its governance design.

Mining creates value by creating a virtuous cycle between transacting in the mined currency and generating new blocks. As currency holders exchange with others (whether for other cryptocurrencies or fiat currencies), they create information that has no value unless it is mined into successive blocks. By mining, miners enable currency transferability and therefore contribute to the value of the currency for everyone.[33] But mining creates value in a more essential way, that is, by implementing blockchain governance decisions in the form of software updates. Individual members might not be aware of or interested in these governance decisions, but the distribution of software updates is key to the proliferation of the blockchain.[34]

In brief terms, economists distinguish public goods from private goods based on excludability and use. For example, a classic textbook definition explains that public goods exist because “[i]t is generally considered impossible to exclude those who refuse to pay voluntarily for public services, such as defense or police protection, from consuming these services.”[35] Thus in general, “non-rivalrous” goods or services are those that are not depleted by use, while “non-excludable” goods or services are those that cannot be furnished to some, without being furnished to all.[36]

A quintessential example of a non-rivalrous and non-excludable service is a state’s use of military force to protect against would-be foreign invaders. It would be virtually impossible for such national security efforts to protect only some members of the state, while leaving others vulnerable to attack. Provided for one against an outside threat, military defense protects all.[37] This is the essential nature of cryptographic mining: provided for one transaction or a set of transactions, successful mining creates the means for additional trustless transactions, protecting all participants against fraud.

Moreover, blockchain protection of all the participants comes at no cost. As opposed to conventional state protection in a physical world, where the cost of protection is quite high, in the digital realm, the cost of protection has zero marginal cost.[38] Software code is easily copied, modified, and spread at high speed to every computer of the network, ensuring that every participant follows the longest and strongest chain. The digital nature of blockchain protection offers a higher degree of adaptability and malleability in case of an attack.

C. Tax Cryptographia Emerges

Because they use voluntarily established fees and variable rewards to maintain their systems, some might reject what cryptocurrency founders do as taxation. But not everything a state does to fund a government is immediately recognizable as taxation either. For example, many states raise funds by licensing or selling state-controlled resources,[39] by directly owning the means of production,[40] by interjecting themselves as a sole buyer of domestic goods or services,[41] by printing money, and by borrowing funds.[42]

Even though these policy choices may not be classically viewed as “taxation” in the formal sense, each of these activities has the same effect as taxation in the sense that each places resources under the direct control of those making governance choices, and beyond the reach of individuals.[43] Each might be characterized as economic equivalents to taxation, indirect forms of taxation, or taxation by another name. Many of these activities describe what founders effectively do when they design incentives to ensure block production and investment in their cryptocurrencies.[44]

Despite the libertarian leanings that have driven enthusiasm for cryptocurrency to date, it should not be surprising that the development of quasi-public goods and the means to pay for them through required contributions are two fundamental aspects of cryptocurrency systems. Tax cryptographia emerging from these design decisions provides some affirmation of the notion that fiscal policy is key to building virtually any complex form of society, even when the designers expressly sought an alternative to the coercive power of the state.[45]

III. A Policy Assessment of Tax Cryptographia

If the foregoing characterizations of cryptocurrency fiscal policy choices are apt, then tax cryptographia’s essential nature appears to be inflationary in some cases while being regressive in virtually all cases. In state-based tax systems, these two features would likely produce strong public opposition, leading to political turnover. But in cryptocurrency systems, strong opposition leads to dissent, fracture, and on occasion total systemic failure.[46] Whether cryptocurrency founders are learning or will learn from the vast experience of taxation within political organizations remains to be seen.

A. Often Inflationary, Inherently Regressive

Tax cryptographia is often inflationary in the sense that when undertaken by a state, printing money to pay for public goods is understood to extract value from the members of society by devaluing their currency and therefore making it more expensive to exchange the currency for other goods. Producing inflation can have distributional effects similar to taxation in that it can move economic value from some community members to others in order to create a good to be shared by all. In the case of cryptocurrency, the block reward allowance to miners is equivalent to printing money, and the quasi-public good is the continuation of the blockchain that makes the currency tradeable for everyone.[47] In a conventional society, inflationary policy will presumably be accepted so long as existing holders will accept the periodic dilution of their currency because they believe that the policy will increase the value to all holders in the long run; presumably the same logic extends to cryptocurrency systems.[48]

It is worthwhile examining the temporal nature of blockchain production rewards where the founders have set a finite number of tokens to be produced, thus setting a limit on the built-in capacity for inflation. This is the case for Bitcoin, which has been designed to reach an upper limit of twenty-one million. The enforced cap is seen as infrastructural protection against inflation. Yet given the high cost of Bitcoin block production, without an alternative plan in place, the end of rewards will result in an escalation of transaction fees.

The transaction fee structure makes tax cryptographia appear inherently regressive, perhaps especially in the absence of inflation as an alternative payment system. The cost of transaction validation is typically imposed as a flat fee, such that those with fewer assets must pay the same to have their transactions recorded as those with much more. This is regressive in the economic sense that it defies the impact of the declining marginal utility of money, that is, the utilitarian theory that the value per unit of money declines, the more one has of it.[49] Thus in common terms, a single dollar means a great deal to a person who has very little, but it means much less to a very wealthy individual.

The possibility of paying a higher fee to accelerate the validation of certain transactions makes tax cryptographia additionally regressive, while also negating the egalitarian attraction of blockchain in more general terms. Those capable of paying higher fees accelerate or privilege their transactions over others, creating a de facto hierarchy within the decentralized network. Because of their authority in maintaining the ongoing viability of the blockchain, miners can use the versatile fee structure to assert their authority and preferences without warning, review, or redress.[50]

In the near term, the impact of the inflationary and regressive nature of tax cryptographia is unclear and may be negligible. To date the value of existing cryptocurrency tokens appears largely independent of inflationary policy.[51] Speculation and herding behaviours by investors, imperfect public perceptions, market competition and the cost of block production appear to be key price determinants.[52] Even so, researchers find that the major cryptocurrencies, especially Bitcoin, continue to be perceived as viable investments, including in terms of balancing a diversified portfolio and hedging risk.[53] Moreover, cryptographic technology is an innovative development that continues to attract attention and investment, and is likely to evolve rather than disappear.[54] If so, the fiscal policy of cryptocurrency will likely evolve as well.

B. Tax Cryptographia is Inevitable

The likely future development of cryptocurrency technology implies that some form of redistribution is inevitable, whether or not characterized as taxation. This is consistent with the idea that taxation is more or less inevitable to build virtually any functioning cooperative enterprise, whether within the concept of a nation-state or otherwise. For example, Robert Nozick demonstrated that all builders of complex polities will cooperate to fund a basic set of public goods in order to make it possible for them to function as a society.[55] He referred to the society that agrees to a minimal set of basic public goods—the minimal or “night-watchman” state—as essentially redistributive because the necessary commitment involved assigning a monopoly over violence to a collectively approved government, thus pooling resources to pay for security.[56]

The baseline of Nozick’s framework for cooperation in a night-watchman state is a pre-existing physical world. In physical terms, resources exist, and people are capable of manipulating, managing, recreating, and adding value to them. But to do so effectively and continuously requires removing violence from the market as much as possible, to ensure that exchanges can take place without distortions caused by compulsion. Thus, Nozick posits that anyone seeking to create a free market must replace a state of nature featuring survival of the fittest with a negotiated society that creates and protects the means for trade by removing the threat of physical violence.[57]

In a cryptocurrency system, it might seem that there is no need for night watchmen because decentralization has eliminated the need for trust as a matter of governance. However, as shown above, it is vitally necessary to produce the means for undertaking value-creating activity by producing software updates which are disseminated and effectuated (such as through mining). Even when characterized as general-purpose in nature, the design of these updates will ultimately dictate the behaviour of the users. In every update, political choices are embedded into the code, whether intentionally or not.[58] Different codes have distinct consequences on the network as a whole, supporting certain code structures or facilitating certain actions over others.[59]

Accordingly, there is a strong case to be made that cryptographic mining is akin to a public good in terms of its construction of the basic means necessary to maintain the cryptocurrency and potentially to increase its value over time. If so, then the system of rewards and fees for miners can be compared to a tax system which distributes costs and benefits to the participants within the system. The choices made by cryptocurrency founders to date are often inflationary and typically regressive. They also seem unsustainable, as fees and rewards may be eclipsed by the cost of mining in the face of speculation-induced price volatility.[60] It remains to be seen whether these fiscal choices will be acceptable in the long run, and if not, whether cryptocurrency founders, miners, and investors will be capable of designing alternative fiscal systems that will be agreeable as well as sustainable.

Conclusion

Technological change has always offered both challenge and opportunity for achieving social goals through regulation. The emergence and widespread adoption of innovations like cryptocurrency raise traditional regulatory concerns, such as how to effectively regulate public risk through securities law and social contribution through tax law. But because of their unique nature, cryptocurrencies also raise particularly interesting internal governance questions for innovators and consumers, including how decisions about costs and benefits are made within new platforms and modes of commercial and investment activity.

From the conceptualization of cryptocurrencies in the late 2000s through the initial coin offering frenzy of 2017, followed by a sobering revelation of the difficulties involved in practical application for everyday uses beyond the production and marketing of heavily speculative cryptographic assets, most of the legal questions being asked by and about cryptocurrency have been practical ones.[61] They focus on how this technology challenges and is challenged by existing regulatory frameworks and how innovators, investors, and consumers manage regulatory risk. Broader questions about how cryptocurrency developers establish internal governance structures have only recently begun to emerge in scholarship.

Studying the internal governance decisions of cryptocurrency founders and designers helps explain the motivations of the parties in a cryptocurrency system and potentially tells us something about how we understand traditional rule of law processes (and how common perceptions may be changing regarding the rationale of the rule of law). Further, the centuries of study that have shaped the development of modern democratic societies inform (or should inform) cryptocurrency innovators about likely pressures on their decision making. Age-old struggles over tax law ought to be relevant to developers because these experiences have taught societies over and over again that the manner in which funds are pooled and spent on common projects is key to their viability.

Taxation is particularly fascinating to consider in cryptocurrency systems because of the libertarian roots that helped propel widespread enthusiasm for cryptocurrencies. The U.S. Supreme Court case of McCulloch v. Maryland is often cited by libertarian enthusiasts for the famous observation that the power to tax is the power to destroy.[62] But in cryptocurrency systems, the inability to tax likely has a similar result. For today’s cryptocurrency founders, investors and consumers, the decisions made about how to share the costs of basic goods among participants involves a difficult governance question that has vexed governments throughout the ages. To date, it seems that these lessons are largely being ignored. The consequences for the long term viability of applied cryptocurrency technology are yet to be seen.