Cryptocurrencies have gained momentum as a preferred trading and/or investment vehicle across the world and at home. A report published on the CoinDesk website revealed that WazirX – an Indian cryptocurrency exchange – saw an annual trading volume of $43 billion in 2021, a whopping 1,735% increase from 2020. Another domestic crypto exchange, CoinSwitch Kuber, spiked 3,500%. in trading volume over the same period, according to a report published in a major business daily.
The promise of astronomical returns from cryptos has attracted people from all walks of the economy. There are approximately 15-20 million crypto users (as of January 2022), according to a Twitter post from WazirX founder Nischal Shetty.
This is interesting because the increased interest in crypto despite repeated warnings from the RBI about extreme crypto price volatility, money laundering risks, and fears that the government may even ban crypto. The Union budget was to clarify the treatment of cryptos.
Budget 2022 defined cryptocurrencies within the general framework of virtual digital assets, including DeFi (decentralized finance) and NFT (non-fungible tokens). Beginning April 1, any gain realized on the transfer of these digital assets will be taxed at a flat rate of 30% with applicable surtax, and no deductions will be allowed except for the cost of acquisition.
In addition, 1% TDS will be levied on any transaction. Losses incurred in a transaction are not deductible from any other income. Finally, if a digital good is donated, it will be taxed on the recipient’s side on any subsequent sale. The government has thus made the trading of these digital assets a speculative activity like lotteries and puzzles.
While investors have welcomed the recognition of cryptos as a digital asset by the government, some experts believe that the tax rate is high, which could hurt and deter small investors.
However, the tax movement should not be a source of concern for investors. With around 20 million users in India, huge interest in the crypto market (India saw a peak of 641% investors in 2020-21, according to a report by Chainalysis), and no regulator central, it becomes imperative to first recognize cryptos as a tradable asset. The decision to levy the TDS is also welcome as it will ensure that the government will be able to track all such transactions, helping to monitor money laundering activities.
Moreover, this high tax rate can deter small, casual and uninformed investors from the market and prevent them from incurring huge losses. Although the market feared that following the budget announcement, crypto investors would start diverting their funds into stocks to take advantage of a lower tax advantage, no sell-offs were observed.
This could be because the budget relieved investors of regulatory fears that cryptos would be banned.
Not deterrent enough
Although a flat rate of 30% digital tax seems high, it may not be a deterrent for large investors. A look at some of the most traded cryptocurrencies – Bitcoin, Ethereum, Binance Coin, etc. – shows that investors are attracted by the extraordinary profits that can be made by trading them.
Data from Yahoo Finance shows that over the past seven years, Bitcoin has grown at a compound annual growth rate (CAGR) of 115%. Between January 2018 and January 2022, Ethereum and Binance Coin achieved a CAGR of 30% and 151%, respectively. This strong performance came despite two major crises in 2019 and 2021.
Similarly, dogecoin, which started out as a joke on Twitter, saw its price skyrocket after Tesla chief Elon Musk started promoting it. Its price increased from ₹3.93 in March 2021 to ₹21 in October 2021 to ₹11.47 in February 2022.
How to explain such fanciful returns? Research shows that media coverage, celebrity endorsements, FOMO (fear of missing out) factor, price manipulations by “whales” who own 5% of a coin, etc. promote crypto as a transformative asset with endless opportunities, thereby luring investors to believe that prices will always rise.
In a 2020 article “Is Bitcoin Really Untethered?”, published in the Finance JournalProfessors John Griffin and Amin Shams wrote: “Overall, our results provide considerable support for the idea that price manipulation can cause substantial distortion effects in cryptocurrencies.
In a 2019 research article “Sex, Drugs, and Bitcoin: How Much Illegal Activity Is Financed through Cryptocurrencies?”, published in The review of financial studies, authors Sean Foley, Jonathan Karlsen, and Talis Putniņs estimate that around a quarter of Bitcoin users are involved in illegal activities such as drugs and sex, and 46% of Bitcoin transactions involved illegal activities. Thus, the available empirical research shows that non-fundamental factors affect the prices of cryptoassets.
A survey by the University of Chicago’s IGM Forum finds that 54% of American economists believe that a substantial source of the value of decentralized private cryptocurrencies comes from their convenience for use in illegal activities.
India’s 30% tax is much lower than Japan (up to 55%), Germany, France and Austria (up to 45%) and the United States (up to 37%). research by The Oddball. Thus, a higher tax rate is justified if the goal is to discourage speculative crypto trading.
In the United States, businesses and financial firms have started accepting crypto payments, and India may soon follow suit. The 30% tax could be enough of a deterrent for companies that adopt cryptos as a means of payment or investment. However, when it comes to traders and investors, the 30% tax cannot deter them from entering the crypto world.
A higher rate would do nicely given the risk-reward profile when trading cryptos and the overall opacity regarding how crypto prices work. Moreover, given the government’s intention to protect small investors from excessive volatility and fraud, a higher tax rate is entirely justified.
Lakshmi is Assistant Professor of Finance at IFMR GSB, Krea University, and Dash is Assistant Professor at Gulati Institute of Finance and Taxation (GIFT), Thiruvananthapuram
February 21, 2022