Bitcoin Versus the State

If you were a state, you would be absolutely terrified of bitcoin. Cryptocurrencies pose possibly the biggest threat to the state in human history. Bitcoin strikes right at the heart of the power of the state in two ways: (1) its power to tax and (2) its power to inflate the state currency. Without these tools the state has no income and will inevitably collapse. Let us see why bitcoin harms a state in these two ways, why this will happen and what we can expect from a state trying to prevent this from happening.

PREMISES

In this write up I will be using the following premises:

• Market forces control behaviour: Incentives are the driving force behind human behaviour. If you make smoking and drinking more expensive, less people will smoke and drink that would have otherwise. If you provide people with free healthcare, more people will go to the doctor that wouldn’t have otherwise. In a similar way I will argue that if you make fraud easier, more people will commit fraud that would not have otherwise.
• Free Market Efficiency: If there is money to be made, there will be someone making that money. If people are willing to purchase a product and the product is not there, there is a market inefficiency, and market inefficiencies never survive long. You are going to have a hard time paying for a meal in rural China with Euros, but you might have not as hard a time in New York, and you will definitely have no problem at JFK International Airport. That is because there is no money to be made selling goods for Euros in China (no tourists), some money to be made in New York(many tourists) and a lot of money to be made at JFK International Airport (only tourists) selling goods for Euros. Similarly i will argue that if enough people are willing to pay in cryptocurrencies such that a market inefficiency occurs, that inefficiency will be solved one way or another.
• Supply and Demand: The higher the supply of a good, the more the price of the good converges to the production cost. If you manufacture coats for 100 dollars but sell them for 200 dollars, there will be a window for someone else to (a) produce a coat of the same quality and sell it for under 200 dollars or (b) produce a coat of higher quality and sell it for the same price. In either case, you lose.

TAXATION

For a person like you and me there are basically three ways to acquire goods. You can (1) acquire something unowned by declaring ownership over it, (2) acquire something owned by trade or by gift or (3) acquire something owned by declaring ownership over it (theft). It is important to note that all property was once unowned and has thus been appropriated at some point by someone. If not then there would have to exist some piece of property that has had an owner throughout time, which is clearly absurd. Of course there are also those who claim that property does not exist. These are communists/socialists and should be ignored. The above list applies equally well to all goods, including money. Money can be found (although technically it still has an owner, it is effectively impossible to find him and lost money should therefore be considered abandoned in all but special cases), money can be acquired by trade or by gift and money can be stolen.

Now we come to the state and immediately we run into some complications. The state is a does not have a body of its own and instead employs people into its service. These people should want to be paid for their service. After all, they are spending time in service of the state and time can only be spent once. The state thus needs money to pay these people before these people can even begin to make money for the state to be paid with. Moreover, most modern states have some some of redistributive policy in place, think social security or health care, that, at least in the short term, only cost money. The state therefore needs another income, and it finds that income in taxation (theft). To survive, the state needs to appropriate part of the income of every citizen that lives within its borders. It is only through taxation that it can find the money to spend on expensive government programs.

Therefore, without taxation a state will not be able to survive unless methods of extreme inflation are used, and even then it won’t last long. The removal of tax income would reduce the state to something akin to a private enterprise. Left to the mercy of the free market it would have to persuade instead of coerce money out of its subjects through provision of quality products at competitive prices instead of violence.

INFLATION

A second way for the state to provide itself with money is through inflation. The state finds itself in charge of the money supply, and in particular is the only entity allowed to print money. If we accept the law of supply and demand, we accept that when supplies rise and everything else stays the same, prices drop. Scarcity paired with demand is the main determinant of price. Sand is cheap since no one wants it and there is tons of it, gold is expensive since everyone wants it and there is only some of it. Similarly if you increase the money supply, value is lost. However, the value is not lost until the new money is introduced into the supply. The simple act of printing money does not reduce the value of existing money. Consider the example of diamonds. Diamonds are not very scarce at all, in fact a very large supply of diamonds exists. However, most of these diamonds are kept out of circulation and therefore prices are high. As long as new money is kept out of circulation, prices remain the same. Only after it is introduced into the money supply, value is lost. This allows the state to print money and to spend money at present value, but after that money is spent the value of all money immediately drops proportional to the amount of money introduced into the supply. By printing money the state therefore passes the cost of its spending to the citizen.

For example, say there are 100 dollars in circulation in a small community, and the community leader needs a new pair of shoes. Shoes are 10 dollars. The community leader does not have 10 dollars but decides to print 10 dollars to pay for the shoes instead. The community leader pays for the shoes with the 10 dollars and acquires 10 dollars in value. The shoe salesman obtains the 10 dollars, but the money supply is inflated by 10% and so the shoe salesman actually only obtains 9 dollars in value. Not only does the shoe salesman get less than he bargained for, but also his savings are reduced by 10% and everyone elses savings too. Not physically of course, the dollar amount stays the same, but the value of their dollars drops by 10%.

TAXING BITCOIN

Currently taxation is made very easy for the state. In fact, it is made so easy that the state rarely even has to actively coerce citizens out of their hard earned money. This is because (1) the state demands you to honestly tell it how much money you make and (2) posesses the means to check if you are telling the truth. That is, the state regulates all business within its borders, including banks, and therefore effectively has a complete overview of your entire income and all your belongings.

Bitcoin enters the stage and everything changes. With Bitcoin, or more accurately, with crypto currencies becoming more and more popular, and with people starting to convert more and more of their fiat currency to ever deflationary crypto currencies it becomes hard to impossible to check a citizen’s savings. It therefore becomes that much more difficult for the state to enforce taxation. When we also start to see person to person, person to business and business to business transactions in crypto (and we will, as I will explain in my next article) this problem only worsens for the state. The state will lose entirely option (2) and will have to rely only on option (1). The state will have to trust its citizens to be telling the truth about their savings, income and spending. It should be obvious that this creates a massive incentive for the citizen to commit tax fraud. With a very large upside (in some countries as much as 80% of a citizen’s income is taxed) and a very small chance of getting caught, only the most risk averse citizens will refrain. The mere existence of this option will seduce almost everyone to commit even a little bit of tax fraud, with very serious consequences for the state. The state will be forced to resort to ever more coercive measures to procure its tax income, while receiving every less revenue to fund these measures. Funding for many state programmes will have to be slashed, which in turn will anger many citizens, incentivising them even more to pay less taxes. The resulting loop of receiving less tax revenue to slashing budgets to receiving less tax revenue will not end well for the state.

INFLATING BITCOIN

There will never be more than twenty one million Bitcoins in existence. Moreover, this upper limit of twenty one million is constantly decreasing. Your bitcoins are not physically in your posession. Instead, your bitcoin stash is kept in a “wallet”, which is really just an address on a ledger kept by a lot of people at the same time. You prove ownership of a certain address by solving a little cryptographic puzzle with your private key. If this key is lost, access to the funds is lost and it becomes effectively impossible to recover them. Therefore whenever an owner of an address dies, the total supply decreases. Whenever someone loses his address, his supply decreases. Whenever someone sends funds to a wrong address, the supply decreases. Even though bitcoins cannot be destroyed each case effectively removes the bitcoins from circulation. No one can decide to “print” more Bitcoin, as the network is decentralised. This makes Bitcoin a deflationary currency, gaining value over time instead of losing value over time like inflationary currencies.

SIDENOTE: DEBT

A critical reader may note that there is a third way for a state to generate income. When a state does not want to tax its citizens more and does not want to print more money for whatever reason, it can decide to borrow money from whoever is interested in lending. I only want to remark here that as state income declines and state debt increases the state’s credit rating, as determined by independend credit rating agencies, will fall to ruin prohibiting it from using this as an effective means of income.

CONCLUSION

As cryptocurrencies become accepted by the general public as currency and store of value, states will start having a harder time making ends meet. To see this is true you simply have to ask yourself this question: If I had the option not to, would I still pay taxes? Even if you yourself answered no, I would argue that many people would answer yes. But a fairer question would be this one: If I had the option to pay exactly as much taxes as I wanted to pay, would I pay the prescribed amount? The answer to this question can only be that you would pay the amount you wanted to pay. After all, if you choose to pay the prescribed amount, that amount is the amount you want to pay. Now we only need to ask ourselves this: Do most people want to pay less or more taxes? Clearly the answer to this question is that most people would desire to pay less. After all, the counterpart to under-the-table work is work. That is, the extreme on one end is to pay taxes, and the extreme on the other end is to pay no taxes. The spectrum does not extend past paying taxes, the idea of deliberately paying more taxes than you owe is simply too foreign. Similarly, the counterpart to dodging taxes is to pay taxes, there is no deliberate paying of more taxes than one is owed. Therefore, any divergence from the standard of paying taxes will point towards the not-paying-taxes side.

Let us try and make this more precise by defining the a tax-preference spectrum from zero to one, where zero is equivalent to “wants to pay none of the owed taxes” and one is equivalent to “wants to pay all owed taxes”. We can define one’s position on the scale by the quotient of their preferred tax rate over their actual tax rate. For example, John owes the state 100 dollars in taxes, but wishes to pay only 50 dollars. His tax-preference rating is 50/100 = 0.5. Now since most if not all people populate the spectrum somewhere between zero and one, we see that in the ideal situation for the citizens of the state the amount of taxes paid is always lower than the amount of taxes owed. After all, the sum of all taxes ideally paid is simply the average of all tax preference scores times the total amount of taxes due, and since most everyone scores under one on the tax-preference scale, the average will definitely be lower than one.

Note that above we use the word ideally in a sense that some may not agree with. I use the term “ideal situation” to mean the situation where everyone is fully in his right to act in the way he desires. The results of such a situation may not be as desired for everyone, however. For example, most people prefer clean air, but most people do not want to pay a lot of money for clean air. Therefore, in the ideal situation where everyone is allowed to act as he wishes the result may be a drop in air quality, which no one desires. However, everyone desires his level of pollution over the resulting drop in air quality and therefore the situation can still be described as ideal in this sense. Similarly, some tax funded programmes may have to be scrapped if people decide to pay the amount of taxes they want to pay, and if they make use of these programmes, they may find the results of their actions to be undesirable. They may adjust their behaviour in the future or they may not, accepting that they prefer spending less taxes than enjoying their tax funded programmes.

Note further that above the word “rights” is used, and some people may object by saying that people have a “right” to clean air. We only need to quickly remark that a rule can only be promoted to a right if it is universalisable. As different people have different standards for “clean air”, one particularly dust-phobic person’s right to clean air may prohibit the entire world’s use of fire to warm their bodies or cook food.

Inflation will also be a much less reliable source of income, as people stop using state issued currency for transactions and savings and switch instead to cryptocurrencies for their reliability and inherent deflationary properties.

In conclusion, without drastic action states will not survive the switch from fiat to crypto. This brings us to the final section of this article.

PREDICTIONS

With the crypto revolution in sight and with cryptocurrencies posing such a threat to the power of a state, there are a couple directions a state can go in. A state can (1) not recognize the threat posed by cryptocurrencies and do nothing, it can (2) recognize the threat posed by cryptocurrencies and do nothing or (3) recognize the threat posed by cryptocurrencies and do something. Situations (1) and (2) lead to state failure by the mechanisms described above and so assuming competency of the state in recognizing threats to its power we conclude a state should choose option (3). In choosing to try and survive the state can go in two general directions. It can (1) try and prevent the switch from crypto to fiat from happening or (2) try and make the best of the situation.

In the first case, where the state tries to prevent a takeover of crypto currencies, it might try to pass a sweeping ban of all crypto currencies. Not wanting to look like the bad guy the state will pass these bans off as “consumer protection”. The state may say something like “crypto currency markets are unstable and unregulated, and consumers should be protected from losing their money”. We only need to take a short trip back to 2008 to see how well consumers are protected by heavy regulation of markets. The motive is of course not the protection of citizen’s savings but the protection of its own power. After all, if the state cared at all about its citizen’s savings it would first and foremost stop inflating the money supply, which directly affects savings in a bad way.

In the second case a state may try regulating crypto currencies. However, this will only affect centralized cryptocurrencies and crypto currency exchanges, and will only make it so that these crypto currencies have a hard time and these exchanges lose business and business switches instead to decentralized exchanges where people will trade decentralized crypto currencies. Attempts at regulation will only drive the crypto sphere to more decentralization, and will postpone but not stop the state’s demise.

Another option in this case is to regulate end points. Right now, crypto currency adoption is not yet widespread enough and there are certain points along the chain of transactions where the crypto world ends. For example, you may have an amount of Bitcoin but you cannot pay for your groceries in Bitcoin. This means that you have to convert your Bitcoin to fiat, and then use that fiat to purchase your groceries. I will call the points where such a conversion needs to occur end points. Currently there are a lot of these end points, but the amount of these end points will start to shrink as people start to accept crypto currencies everywhere. For example, the end point in the example above dissapears when the store owner starts accepting payment in Bitcoin. I can now purchase my groceries in Bitcoin without converting first to fiat. As soon as an end point dissapears, the state loses important information. For example, in the example above the state can no longer check transaction records for that store and therefore has no clue what amount of stock that store is moving. The store can now easily cook the books and the state has no way to check if it did. It is therefore in the state’s interest to maintain and regulate as many end points as it can. We can expect, for example, mandatory state issued cash registers, where all crypto transactions need to pass through state issued equipment. We can also expect states to issue a state cryptocurrency to try and maintain control. These currencies will not prove very popular in the long term as they lack the essential characteristics that make other crypto currencies desirable, such as decentralization and deflation.

One other prediction that we can definitely make is for the law to be adjusted to include very high penalties for hiding crypto currency savings or income in the future, and for penalties for tax evasion to go up drastically in the future as well. It has always been the case that where the chance of getting caught is very low, the cost of getting caught should be very high for the punishment to be an effective deterrent. If a thief wanted to steal 100 dollars and he estimated his chances of getting caught to be 50%, he might still take his chances if the punishment were only 200 dollars. In fact, more risk taking individuals may even commit the crime if the punishment was 400 or 800 dollars. The cost should be drastically higher than the potential reward if, say, the chances of getting caught for a crime should approach zero. We can expect this to be the case with crypto currency tax evasion as end points start dissapearing and the no longer knows what you own, what you earn and what you spend.

We are already seeing worried states making their move. In the US, Coinbase, a popular crypto currency exchange site, was recently ordered to report 14355 users to the IRS. In China, Indonesia and Vietnam heavy regulatory measures have already been taken, ranging from regulation of exchanges to sweeping bans. More interesting moves have also been observed as, for example, Ukraine has drafted a bill to exempt crypto currency income and profits from taxation. A noteworthy quote by Bohdan Danylyshyn, chairman of the NBU council, from this article is the following:

“I am convinced that any attempt to restrict the functioning of such a market may have the opposite effect, namely, to facilitate the shadowing and delegitimization of processes associated with it.”

Another interesting move comes from Venezuelan president Nicolas Madura who is looking into launching his own oil-backed cryptocurrency to circumvent US-led financial sanctions.

Wether these moves will prove succesful is another question entirely. Nevertheless we are entering a very interesting period in human history. Will we progress to a stateless libertarian order based on property rights contractually solidified in the crypto sphere, or will we devolve into authoritarianism or lawless anarchy? This might be the closest the western world has ever been to achieving total freedom for everyone