Cryptocurrency Taxation: Pigouvian Taxation Does Not Solve The Problem Of Tax Evasion

By Manas Agarwal, a fourth-year student at NLSIU Bangalore


Cryptocurrency (‘crypto’) is an ideal example of the intersection between finance and technology. This is because technology makes crypto decentralized and unregulated, which gives rise to finance-related concerns. One such concern is taxation, and this is precisely the backdrop against which this article is set. The focal point of this article is the taxation of crypto that was put forth in the Union Budget of 2022-2023 (para 131). Consequently, the Finance Act, 2022 amended the Income Tax Act, 1961 (‘ITA’), with effect from April 1, 2022.

Structurally, the article is divided into two parts. First, the author will critique the scheme of taxation of crypto prescribed under the ITA. Further, the author will flag some definitional issues in the present scheme of taxation. Second, the author will employ the law and economics framework of analysis to argue that the true purpose behind the present scheme of taxation is deterrence through negative externalities. Consequently, the author proposes to argue that the present scheme of taxation for cryptocurrencies is not sound either from a revenue maximization perspective or from the standpoint of addressing a negative externality.

Issues pervading the taxation of crypto under the ITA

The Finance Act 2022 inserted four components in the ITA:

  • The definition of Virtual Digital Assets (‘VDAs’) under Section 2(47A) of the ITA.
  • An explanation clarifying that VDA shall come under the definition of ‘property’ – section 56(2)(x) of the ITA.
  • Imposition of 30% tax rate on transfer of VDAs – Section 115BBH of the ITA.
  • Tax will be deducted at source for payment of consideration for the transfer of VDAs – Section 194S of the ITA.

All these provisions pose policy challenges, including an increase in compliance costs. Compliance costs cover all costs that a taxpayer, as well as a third party, has to bear to comply with the tax law and other requirements of the tax authorities. Section 115BBH imposes a flat rate of 30 percent on the transfer of VDAs. This leads to an increase in compliance costs as; firstly, a flat tax rate obliterates the distinction between income from capital gains and business income. Under the ITA, the former is charged at a lower rate. However, in the new tax regime, a person will not be able to seek the benefit of a lower tax rate. Secondly, Section 115BBH does not allow setting off the loss from the transfer of VDAs against any other income.

Additionally, Section 194S mandates every person (except those exempted) paying consideration in exchange for crypto to withhold tax at 1%. First, ‘Specified persons’ is one category that has been given certain exemptions from the section. Though the criteria to identify a specified user are elaborated on in the explanation, further information is required to assess who meets those criteria. This will increase compliance costs and also result in a decline in trading volume since users will stop dealing in crypto due to anonymity concerns. Second, the compliance costs will be significant in crypto-to-crypto transactions. This is because, a plain reading of the section suggests that firstly, both parties will have to deduct tax at the source, and secondly, the fair market value of the crypto will have to be ascertained to deduct the tax at the source.

The real purpose behind the taxation of crypto is that of establishing control over virtual digital assets

In this segment, the author, using different theories of taxation, argues that the government wishes to disincentivize crypto trading and crypto investment.

i.   Tax as Revenue Maximization

The first view reflects the traditional theory of taxation, which advocates that the purpose of taxation is revenue maximization so that public funding activities can be financed.[1] Hence, this view will advocate that due to the large trading volume of crypto, it can serve as a good source of revenue. However, if revenue maximization is the purpose, then the existing scheme of taxation of crypto is not optimal. This can be understood through Adam Smith’s canons of taxation. The second and third canons, the canons of certainty and simplicity, state that the levying of taxes should be certain, non-arbitrary, and convenient for the taxpayer (pages 36-37). Moreover, the fourth canon states that the difference between the amount in the public treasury and the amount recovered as tax should be minimal (pages 36-37). In other words, costs such as the salary of tax officers, the costs of legislation, etc. must be minimal. Net revenue equals administrative costs and compliance costs subtracted from gross tax revenue.[2]

As mentioned above, the prohibition on setting off losses from crypto (Section 115BBH) and the onerous Tax Deducted at Source (‘TDS’) requirements (Section 194S) increase the compliance cost. Furthermore, vagueness in the definition of VDAs and a lack of a coherent mechanism for the valuation of fair market value will increase the administrative costs of litigation, appeals, and explainers. Hence, the goal of revenue maximization will remain unachieved because of the high compliance costs.

ii.  Tax as Negative Externality

The central argument of Modern Monetary Theory is that sovereign governments face resource constraints, not financial constraints. Hence, the theory advocates that the traditional mechanism of first imposing taxation and then spending on public financing is outdated and works only in times of commodity-based money. With the introduction of fiat money, there is now a mechanism in which the government spends first and imposes taxation later.[3] This is because, unlike non-state actors which use the currency, the state issues it. Hence, revenue maximization is not the sole purpose of taxation.

One such purpose is Pigouvian taxation. Pigouvian taxation is used to minimize the deadweight loss in cases where the society faces a deadweight loss due to the private cost being less than the external cost. For instance, pollution imposes external costs on society that are not borne by the private actor, the polluter. Hence, a tax is imposed on the polluter to ensure that, while deciding how much to pollute, the polluter internalizes the external costs (for example, carbon tax, plastic tax)[4]. The author argues that the present system of crypto taxation is an example of Pigouvian taxation.

The Indian regulatory landscape has been hostile towards crypto. For instance, Section 8 of the Banning of Cryptocurrency and Regulation of Official Digital Currency Bill, 2019 states that direct/indirect mining, generating, holding, selling, dealing in, disposing, and issuing are declared offenses and can have penal consequences. Furthermore, all these offenses are non-bailable and cognizable in nature (sections 8(1) and 12(1). However, this staunch opposition does not extend to Central Bank Digital Currency (‘CBDC’), which is a digital token recognized as a legal tender (para 111). The exclusion of ‘Indian currency’ from the ambit of section 2(47A) of the ITA saves CBDC from falling within the definition; otherwise, it would have also been treated as a VDA under the ITA. This is because even private digital currencies fulfill the three roles of money (store of value, medium of exchange, and unit of value). Hence, the elephant in the room is not the ‘digital’ nature of private crypto but the lack of government control over it. This happens because; first, unlike CBDCs, private crypto is not easily traceable, and hence monitoring, reporting, and surveillance is difficult, and; second, unlike CBDCs, crypto operates independently of financial intermediaries such as banks, as crypto is only dependent on the demand and supply in the market (pages 38, 42). Hence, the central bank loses control in addressing concerns such as inflation because crypto is independent of the monetary measure of interest rates.

The government will justify control through taxation because decentralization and (pseudo) anonymity present in the crypto transaction make crypto a tax haven. Furthermore, there have been numerous instances of crypto being used to finance terrorist activities and in money laundering. Therefore, people who illegally deal in crypto impose external costs on society (if there is an increase in criminal activities and the focus of the State is on preventing such activities, then there might be a resource crunch due to which the welfare activities of the State are compromised). Hence, a high tax rate will act as a deterrent, and the external costs due to crime will be internalized. Therefore, crypto taxation represents a Pigouvian tax.

However, characterizing crypto taxation as a Pigouvian tax by itself is insufficient. This is because a cardinal principle of taxation is neutrality. It means that taxation should not be used to distort consumer choices, and consumers should be allowed to make a decision based on welfare and/or economic reasons. However, one might argue that Pigouvian acts as an exception to neutrality since it establishes an equilibrium between private costs and social costs. Though this is true, the exception is not being drawn in the present case. This is because the issues concerning tax evasion, illicit activities, etc., and the imposition of a Pigouvian tax as a solution to these issues do not have a direct correlation. Under the ITA, the prominent mode of filing returns is based on self-assessment (sections 139, 140A) where taxpayers must assess their tax liability themselves based on factors such as (i) income, (ii) taxable income, (iii) head of income, (iv) concessions, (v) exemptions, and (vi) TDS. Self-assessment helps to address the case of crypto taxation because of the anonymity coupled with high compliance costs. Furthermore, techniques of summary assessment, (section 143(1)) regular assessment (section 143(2)), and re-assessment (section 144) are not adequate to receive taxation on crypto because crypto acts independently of banks and financial institutions and posits a cloud of anonymity. Moreover, it can be said that the probability of self-assessment and third-party reporting is indirectly proportional to the compliance costs and directly proportional to the probability of detection of tax evasion. As stated before, compliance costs are high and the probability of detection is low in a crypto transaction, thus, a model of Pigouvian taxation for crypto by itself is not the optimal solution.


The present scheme of crypto taxation suffers from various policy concerns. This is because Sections 115BBH and 194S of the Indian Tax Act raise compliance costs, and hence cryptocurrency taxation is not optimal for revenue maximization. Furthermore, using crypto taxation as Pigouvian taxation is not helpful, because the issue of tax evasion, illicit activities, and the solution of levying a Pigouvian tax, do not have a direct correlation. This is further aggravated by the low probability of detection because of self-reporting. Hence, (a) the present taxation of crypto under the ITA does not solve the fintech issue of tax evasion due to anonymity inherent in the technology used in crypto and (b) the taxation of crypto does not achieve the goal of either revenue maximization or Pigouvian taxation.

[1]Beverly I. Moran, ‘Taxation’ in Mark Tushnet, and Peter Cane (eds), The Oxford Handbook of Legal Studies (OUP 2012) 377.

[2] ibid.

[3] L. Randall Wray, Modern Money Theory: A Primer on Macroeconomics for Sovereign Monetary Systems (2nd ed, Palgrave Macmillan 2015).

[4] ‘Environmental Taxation’ in James Mirrlees (ed), Tax By Design (OUP 2010)231.

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