Few things have loomed larger in the economy recently than cryptocurrency. Rarely does a week go by when it is not in the news. The number of users of cryptocurrency has increased from 5 million in 2016 to 516 million in 2023.

As it becomes an increasingly more common unit of exchange, and especially as a type of investment in the economy, collecting taxes from cryptocurrency holdings is increasingly important. This is made more challenging by the absence of transparency found in many cryptocurrencies. Transparency refers to the ability to identify who holds the cryptocurrency assets. A key challenge to crypto tax enforcement turns out to be the absence of third-party reporting mechanisms in many cryptocurrency exchanges.

Tony Zhang (right), adjunct clinical assistant professor of finance, and Vicki Tang (Georgetown University) undertook a study titled “How Transparency Shapes Tax Policy Effectiveness in Market Transitions: Evidence from Cryptocurrency Price Disparities” that examined whether and how the prices of cryptocurrency respond differently to local statutory tax liabilities under varying levels of tax reporting transparency.  They found that greater tax reporting transparency amplifies the capitalization of statutory tax liabilities into cryptocurrency prices.

The researchers examined whether the prices of the same cryptocurrency respond differently to local statutory tax liabilities under differing levels of tax reporting transparency. And if they did respond differently, how that manifested. They also examined the effects of recent legislative changes that either increase statutory income tax liabilities or enhance tax reporting transparency.

Transparency is important

Transparency proved to be extremely important for tax compliance. Greater tax reporting transparency enhances tax compliance, leading to higher anticipated tax burdens even without changes to statutory tax liabilities. Part of the transparency they examined included what are known as "know your customer" (KYC) requirements. “Traditional brokers in the US require you to actually release your information,” Zhang explained. With this identifying information, brokers share this information with the government, which can track tax obligations.

When applied to the cryptocurrency market, they found that greater transparency in cryptocurrency tax reporting enhances tax compliance, raises anticipated tax burdens, and amplifies price adjustments to statutory tax liabilities.

“We actually determined that the effectiveness of the crypto tax policy is stronger in a KYC compliant exchange, where traders must verify their identities in the mechanism,” Zhang said. “The KYC reduces the anonymity and increases the perceived tax reinforcement or enforcement risk. This encourages compliance.”

Policy implications of regulatory gaps

Zhang’s research provides critical insights for policymakers on designing effective tax policies as cryptocurrency markets evolve from unregulated to increasingly regulated environments.

“If you actually make profit by trading in cryptocurrency – Bitcoin or Ethereum – then you need to pay tax,” Zhang said. “In the past, they passed some regulations on this. So, you have to pay the crypto tax, but no one thought to actually put in the third-party reporting mechanism – which is important to have the tax reporting transparency requirement in place.”

Award-winning research

In recognition of the unique insights their research provided. Zhang and his coauthor Vicki Tang received the Best Paper Award at the 25th National Business and Economics Society Annual Conference.

“NBES has a mandate as a multidisciplinary professional organization which actually focuses on promoting interdisciplinary research that is professional, practical and theoretical in nature,” Zhang said. “This is one of the largest societies in the business and econ domain, and they have had an annual conference for more than two decades. They really try to highlight the promote the research that has both mandates of being theoretical and having practical implications. Our research paper makes the contribution in theory and simultaneously also has the practical implications.

“We actually make the contribution for this particular space, the crypto space. Practitioners, academia, researchers, and regulatory agency can all actually count on our research and our discovery to make either further modification over the regulatory framework and simultaneously make an informed investment position.”

Their research was supported by a Blockchain Analytics grant, which provides funding for research on blockchain in order to answer questions about market sentiment, investor behavior, industry adoption, and cryptocurrency valuations.