Can incentives lead to better compliance in crypto taxation?

Renowned American economist Steven D Levitt famously once said that incentives are the cornerstone of modern life.

Levitt described the process as as urging people to do more good deeds and move away from bad practices. The closer you look, you’ll notice that incentives are driving great success and results across public and private sectors.

Starting from recognising an employee of an MNC for a stellar performance to rewarding households with a bag of free rice, lentils, and other supplies to participate in government driven health programmes, incentives have propelled modern life to a large extent.

With tax filing season around the corner, this is a good time to reflect on how this can turn out to be effective for improving compliance, reducing defaulters, creating efficiencies around entering records and  how the crypto asset ecosystem can draw some inspiration from this.

The crypto asset ecosystem can learn from existing models, like Japan's photo-op with the emperor, Taiwan and the Philippines' lottery system, and South Korea's reward mechanisms for compliant citizens.

In India, the Samman Scheme was introduced in 1999 to recognise and reward compliant taxpayers. Although the program was discontinued in 2004, Indian Prime Minister Narendra Modi has repeatedly expressed his desire to reward honest taxpayers.

The role of incentives in crypto taxes

Implementing rewards for compliant behavior has the potential to create efficiencies around record keeping, reduce the burden on tax authorities, and encourage tax compliance.

By recognising compliant behavior, governments can also boost citizens confidence in Web3, which could help increase its adoption. Tax authorities and the crypto industry could explore new and innovative ways to incentivize compliance and encourage taxpayers to meet obligations.

Governments around the world begun taxing crypto assets to increase transparency and generate additional revenue.

In the United States, where there is a large base of cryptocurrency users, many platforms lack proper systems for users to report gains or losses and file taxes accordingly. This is also the case for exchanges in other countries. As a result, tax departments must analyse each individual user's gains and losses at the end of the financial year.

In India, a 30% tax on cryptocurrency gains and a 1% TDS have been imposed. The OECD has released a draft framework in 2022 that provides comprehensive guidance on cryptocurrency tax reporting. However, to encourage users to comply, rewards need to be developed based on Web3 principles.

Creating tax incentives around Web3

In traditional finance, rewards are created based on calculation of costs and benefits. However, this needs to be more than a compliance assurance for the government and needs to be mutually beneficial in the truest sense.

It is important to identify what results are expected from the mechanism, which in this case is better compliance. The tools for incentive design here will have to consider better returns as a result of this compliance.

The innovation in incentive structures should be robust considering the growing popularity of crypto, and India as a hotbed of this ecosystem.

It would be wise to use blockchain technology for crypto incentives since the principle of Web3 is based on it. This will help the law enforcement agencies in keeping track of the progress of their programme—how  it has improved compliance, the methods people employ to use  the incentives and more.

Since the Indian government is on its course to roll out CBDCs in some time, it can consider a select few good actors chosen at random to be part of a small user group for retail CBDC use in areas such as ecommerce, travel, etc.

The law enforcement can also consider partnering with exchanges of compliant users to waive off trading fee for a short period of time as a prize for proactive and correct filing of taxes.

In addition to these, users can be chosen from a pool of crypto users to own validator rights through token holding for government backed blockchain projects. These tokens can be exchanged for fiat by users and they can continue to earn rewards as validators as well.

Several institutions are looking at integrating blockchain in their core systems. It can be a learning experience for users to be a part of these initiatives as node runners and contributors which can only be earned with a clear record of voluntary tax reporting.

Taxpayers can be given a Proof of Compliance certificate as an NFT with records of transactions and gains reported to have a pristine record of all activities for each user which cannot be tampered with.

The same can be tailormade based on an overall survey of the user sentiment regarding their take on different types of incentives.

For example, someone might want to have an experience of running a node on a blockchain that the lawmakers could partner with or they could establish cross border connection for their ventures through CBDCs issued by the government as a reward, equivalent to the fiat currency.

It is important to establish a mutual synergy as a first step towards making the tax filing process a success. This can lead to a stable environment for crypto to grow and operate in.

Besides advocating for low tax rates, the Indian crypto community should also consider speaking in favour of rewarding honest and compliant taxpayers in the virtual digital asset ecosystem since it is largely unregulated and new, and evasion of taxes or misreporting might could simply be due to lack of awareness or avoiding the complications associated with the procedure.

While incentivising taxpayers isn’t a new concept, it is based on the needs and demands of citizens as well as the government’s fiscal policy.

Having said that, this is simply a way to motivate more citizens to stay true to the taxation system. The government in each country has a record of tax liabilities of citizens for both onshore and offshore wealth.

Incentives can play an important role in improving tax morale of citizens instead of creating a system of increased scrutiny and penalization from law enforcement. It has also been observed that sometimes compliant citizens tend to become defaulters which is called the ‘bomb-crater’ effect. But incentives can ensure that honest taxpayers do not take advantage of their clean record to default in the future.

The government needs to project confidence in Web3 and identify the awareness building opportunities even among existing crypto traders in order for any incentive programme to be a success. The incentive in itself can be a Proof of Support of India towards Web3 and initiatives surrounding it.