What Will It Look Like When Taxation and Privacy Collide?

What if instead of private protocols enabling tax avoidance or evasion, privacy in web3 actually enhanced tax reporting?

The merging of Web3 and privacy is creating a unique landscape for financial activities, where the opacity provided by privacy layers could potentially impact the realm of taxation. While البعض might envision an inherent conflict between the two, viewing privacy as a tool for evading taxes, there exists an alternative perspective that presents a more harmonious convergence.

In this scenario, privacy in Web3 could actually enhance tax reporting, offering a “best of both worlds” solution for both individuals and regulators.

Imagine a world of “zero-knowledge taxes,” where individuals can file and have their taxes verified using zero-knowledge proofs. This could be achieved through a trusted, third party application that analyzes a user’s wallets and calculates their taxable events, ultimately generating a summary of the individual’s taxes for the year.

The summary tax payment, along with the proof itself, would then be submitted to the regulating entity, which can use the proof to verify that the tax summary is accurate – without needing to view every single transaction leading up to the summary.

Many privacy protocols today are built with selective privacy, meaning users can elect to reveal certain portions of their on-chain history if they wish. This could serve as another mechanism to establish trust between the tax filer and the regulator.

If a regulator has reason to distrust a submitted zero-knowledge tax proof, they could compel the filer to reveal contested portions of their transaction history. While this may be difficult to enforce on an individual level – considering the likely availability of a variety of selective and non-selective privacy networks – a government requirement for all businesses to use a selective privacy network, for example, could be an effective way to manage corporate taxes.

While still in the conceptual phase, zero-knowledge taxes offer a vision for how Web3 innovation can be harnessed to the mutual benefit of both its users and its regulators.

However, it's crucial to acknowledge the elephant in the room – the possibility of outlawing privacy. We've seen governments swiftly enact measures to restrict crypto, often citing consumer protection or fraud prevention.

For the privacy ecosystem, the standout example is the United States, which recently sanctioned every address that has interacted with Tornado Cash.

With a precedent like this, the scenario painted above may seem particularly unlikely. But it's important to note that Tornado Cash is distinct from the zero-knowledge protocols emerging today – and so are the implications of future sanctions.

When the U.S. government sanctioned Tornado Cash, their aim was to sanction the untraceable, unverifiable movement of funds. The private nature of Tornado Cash wouldn't allow the U.S. government to sanction addresses that only transferred funds (as opposed to other on-chain actions). However, luckily for those regulators, this wasn't a concern.

Tornado Cash is a straightforward protocol that enables only the transfer of funds. By sanctioning the protocol, the U.S. government was able to sanction the undesired action.

This approach will not translate to the emerging wave of more expressive privacy networks, which can facilitate anything from transferring funds to sending messages. Unable to select and sanction specific actions behind a privacy wall, regulators will be faced with a choice: sanction an entire protocol, including all the benign non-financial activity, or adapt and learn how to regulate privacy networks to create a symbiotic relationship between regulator and individual.

A world where tax filers and regulators happily and trustlessly interact with zero-knowledge technology is not right around the corner. Not only does a considerable amount of work need to happen in the Web3 privacy space, but lawmakers also need to warm up to the crypto industry as a whole, let alone more esoteric and technical niches like zero-knowledge.

However, just like death and taxes, privacy technology, too, is inevitable. The evolution of Web3 will continue to integrate more privacy solutions, and both users and regulators will be eventually forced to contend with the technology. Recognizing today that this collision isn't destined to be antagonistic is just the starting point.

Layer 2

Tax Week

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