What Will It Look Like When Taxation and Privacy Collide?

Web3 is at the beginning of a privacy boom. Old-guard privacy solutions like Zcash and Tornado Cash demonstrated the opportunities for privacy protocols, but today’s wave of new layer 1 and layer 2 networks bring expressive computation and complex smart contract capabilities to private networks.

The result of this emerging ecosystem will be a future where all sorts of on-chain activities – financial, creative, data, and operational – will occur obfuscated behind privacy layers. Individuals and entities will grow familiar and comfortable with trustless, private interaction secured by zero-knowledge technologies.

Matthew Niemerg is the co-founder of Aleph Zero. This piece is part of CoinDesk's Tax Week.

When we imagine the future of web3 and privacy, it might be difficult to fit taxation neatly into the picture. At face value, private financial activity seems antithetical to taxation, which today requires transparency by regulators for authentication. Privacy and taxation as contradictory to one another is founded in some reality. Funds that have been exploited from DeFi applications are frequently sent through mixers on private networks that render those funds – and thus their taxable implications – untraceable.

With this narrative stuck in our minds, it’s easy for us to default to a vision of the future where privacy and taxation remain combative. A future made up of two opposing forces: web3 users hiding their taxable events versus lawmakers rushing to catch up and penalizing culprits.

See also: Key Tax Implications of NFTs, Crypto Staking and Yield Farming | Opinion

But what if there was another way to look at the inevitable collision of taxes and privacy networks? What if instead of private protocols enabling tax avoidance or evasion, privacy in web3 actually enhanced tax reporting, resulting in a “best of both worlds” solution for both individuals and regulators?

“Zero-knowledge taxes” describes a situation in which taxes can be filed and verified with zero-knowledge proofs. This could operate through a trusted, third party application that analyzes a user’s wallets and calculates taxable events, resulting in a net summary of the individual’s taxes for the year. That summary tax payment, along with the proof itself, is submitted to the regulating entity, which can verify through the proof that the tax summary is accurate without needing to see every 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 be another mechanism to establish trust between the tax filer and the regulator. Should a regulator body have reason to distrust a submitted zero-knowledge tax proof, they could compel the filer to reveal contested portions of their transaction history. Though difficult to enforce on an individual level – presuming there will be a variety of selective and non-selective privacy networks available – a government requirement for all businesses to use a selective privacy network, for example, could be an effective way to manage corporate taxes.

Zero-knowledge taxes, which are just in the conceptual phase, are not a panacea for the challenges that will arise around crypto taxes in the future for both individuals and regulators. However, they do offer a vision for how Web3 innovation can be used to the mutual benefit of both its users and its regulators.

The world is no stranger to sudden measures by governments to restrict crypto, typically in the name of consumer protection or fraud prevention. For the privacy ecosystem, the significant example is the United States, which recently sanctioned every address that has interacted with Tornado Cash.

With a precedent like this in the books, the vision painted above of the symbiosis between taxes and blockchain privacy may seem particularly unlikely. However, Tornado Cash is distinct from the zero-knowledge protocols emerging today – and therefore so are the implications of future sanctions.

When the U.S. government sanctioned Tornado Cash, what they wished to sanction was 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). But, luckily for those regulators, they didn’t have to worry about this. Tornado Cash is a straightforward protocol that allows only for 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 enable 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.

Read more: Tax and Compliance Challenges Enterprises Face in Crypto | Opinion

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 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 weave in more privacy solutions, and both users and regulators will be forced to contend with the technology eventually. Recognizing today that this collision isn’t destined to be antagonistic is just the starting point.