Why the IRS should classify Bitcoin as a currency

Bitcoin is not a currency, the IRS has declared (and others have agreed). This decision impacts both digital currency traders and consumers using Bitcoin to purchase goods and services. After explaining how the IRS’s categorization of Bitcoin negatively affects market efficiency and the chances of Bitcoin’s mass adoption, I will show that from structural, functional and ontological perspectives, Bitcoin is quite like the U.S. Dollar and other currencies, and should be treated as such.

Why Bitcoin’s classification matters

Speculators and market efficiency. While traders of recognized currencies enjoy the choice between treatment under the tax code’s Section 998 or Section 1256, Bitcoin traders do not. Under 1256, currency traders can classify 60% of their gains as long-term capital gains, even if those gains resulted from short-term trades. Under 998, currency traders can count an unlimited amount of loss against ordinary income — as opposed to the default $3,000 cap for capital losses. Without those options, Bitcoin traders are faced with the $3,000 cap for capital losses and the usual time limits for short- and long-term capital gains and losses. This makes participating in Bitcoin trading less profitable, and therefore, over time, fewer will participate in it. Smaller markets are less efficient, and economists believe that society benefits from market efficiency: the more efficient a market, the more “correct” prices are — and the more optimally resources are allocated. So, less preferential tax treatment of Bitcoin trades means less societal benefit.

Consumers and mass adoption. Given Bitcoin’s categorization as property, consumers are required to treat all spending of Bitcoin as disposition of property. If a consumer bought one Bitcoin for $1,000 yesterday, and pays for $2,000 worth of goods with that one Bitcoin today, that triggers a $1,000 short-term capital gain. This imposes a substantial record-keeping burden on everyone participating in the market. Every transaction involving Bitcoin now carries with it the extra cost of recording the Bitcoin conversion rate at the time of the transaction, for future calculation of the gain or loss versus the cost basis.

Even without considering the possibility of extra taxes, this burden is a substantial obstacle in the way of mass adoption of Bitcoin as a go-to currency for routine purchases. If Bitcoin has benefits over fiat currencies like the U.S. Dollar (and it does), then tempering adoption means forgone utility. And because Bitcoin exhibits network effects, meaning users enjoy greater benefit as the network of Bitcoin users grows, the forgone utility is compounded.

The Cryptocurrency Tax Fairness Act was recently introduced in the U.S. House of Representatives. It would exempt from taxation the first $600 of capital gains from purchases made with Bitcoin and other digital currencies. It is a step in the right direction, and its enactment would be a boon to Bitcoin’s adoption. But it doesn’t go far enough. The remaining tax burdens would continue to stifle Bitcoin adoption, preventing the increased social utility that would follow from its broader adoption. Even apart from these negative consequences, though, Bitcoin should still be recognized as a currency.

Why Bitcoin should be recognized as a currency

The effects on adoption and market efficiency are both consequentialist arguments supporting the idea that Bitcoin should be classified as a currency. In other words, they focus on the consequences to make the case for what should happen. Here are three non-consequentialist points that support the same conclusion, by looking at the way Bitcoin works and what it “is.”

Structure. Bitcoin is a protocol, a database and a network, and because of its categorically diverse component parts, it can appear fundamentally different from fiat currency. But Bitcoin is fundamentally just like other currencies, despite some differences (like not being able to physically instantiate Bitcoin, and the lack of government backing) that do not affect the final analysis. An outline of Bitcoin’s components makes the similarities clear.

• The Bitcoin blockchain — i.e., the distributed ledger that tells us who owns how many units of Bitcoin — is very much like what we’d have if all banks around the world that had accounts denominated in U.S. Dollars got together and created one big database of accounts. Although our bank balances are not currently unified in one database, their current segregation isn’t a necessary feature of any currency. (And that segregation, which has certain disadvantages, might not be long for this world.)
• The Bitcoin code, with which all parties querying or transacting on the blockchain interact and by which they are confined, is similar to — but orders of magnitude more deterministic, knowable, and restrictive than — the “rules” that govern the creation, distribution and transfer of U.S. Dollars. I put “rules” in quotation marks because in our system of fiat currency, the federal government, for example, has discretion when it comes to increasing the money supply. The Bitcoin network (see below), which is tightly controlled by the Bitcoin code, has less flexibility by virtue of the consensus required to change the rules. Over the long term, with the assent of the miners — the people who run the computers that record new transactions and secure the network — the code can be changed. Such decisions are decentralized, and require near universal buy-in. One can think of the differences between Bitcoin and fiat currency in this dimension to be ones of governance structure and procedure — but not ones that bear on whether one or the other qualifies as a currency. Central banks are very different from Bitcoin developers and miners, and flexible control by humans vested with authority is different from determinative, alrogrithmic rules set by consensus. But the important point is that both Bitcoin and the U.S. Dollar have rules, governance, and deliberate bodies making decisions about the rules.
• The Bitcoin network — the linked group of all nodes (or computers that keep copies of the blockchain and update it based on the Bitcoin code) — is like the banks themselves. But anyone can start their own node, and nodes are not autonomous in the same way banks are; the nodes are more like automatons, living out the requirements of the Bitcoin code. Nodes receive transaction instructions from wallets and in turn propagate those transactions to the other nodes in the network. (I’ve simplified things here and left out the miners, who are also nodes but do some extra work that secures the network. I believe this simplification doesn’t affect the analysis). The Bitcoin network is fundamentally similar to the SWIFT international payment network and the Federal Reserve Wire Network. Although those networks operate on trust rather than distributed consensus via blockchain, they are, similarly, electronic communication systems at their heart.
• Bitcoin wallets — the software that lets users send and receive units of Bitcoin — are similar to the terminals that your bank would use to transmit wire instructions. Instead of there being a layer between the account holder and the wire terminal, Bitcoin users have direct access to wallets that let them directly interact with the network. The wallets allow end-users to get “closer” to the network that executes the transfer than do bank account interfaces, but the nature of the system isn’t altered by this proximity.

The components that together make Bitcoin “Bitcoin” are similar to the components of our fiat currency system. And the differences, where they exist, are not crucial to any currency’s classification as such.

Function. When I send you half a Bitcoin, what’s happening? First, I open my wallet and execute a “send” command. My wallet talks to the Bitcoin network, using specific terms required by the Bitcoin code, and the network learns that I am asking to make a change to the blockchain. The change I’m requesting is to reflect that my balance is half a Bitcoin lower, and yours is half a Bitcoin higher (net of fees). After some work is done by the special nodes known as miners, the blockchain is updated to include the new transaction, and anyone looking at the balances of my address and yours will see that your balance is half a Bitcoin higher, and mine is half a Bitcoin lower.

So what is someone buying when she buys “a Bitcoin”? She is paying the seller to ask the network to update itself in a particular way. The seller agrees that in exchange for being paid $X, he will use his wallet to ask the network to make a change to the blockchain. The end result is that the buyer pays to have the ability to send one Bitcoin to someone else, if and when she so desires in the future.

Effectively the same is true when one buys a dollar. Let’s say I run a candy shop and I buy dollars with candy. Every day customers come in and accept my offer to buy one of their dollars in exchange for a piece of gum. I give my customer a piece of gum, and he gives me a dollar. If he pays with a credit card or a check (or if he gives me cash that I deposit), that dollar I’ve bought means that my bank account reflects an additional dollar balance.

Ontology. What is “a Bitcoin,” — what is that thing that one buys, holds or transfers? By having described above the components that enable the existence of the abstract thing that is “a Bitcoin,” I hope that it is easier to get to the heart of the matter, and to avoid being distracted by those collateral concepts.

Leaving interest aside, “owning” that dollar from the previous example means that I now have the ability to, if I so desire in the future, send one dollar to someone else. Just like owning a unit of Bitcoin means just that I have the power to bestow that Bitcoin on someone else later, owning a dollar means just that I have the power to send it on to someone else later. Again, but for the ability to transfer them, dollars don’t mean anything. And apart from the ability to transfer them, Bitcoin units don’t mean anything.

Bitcoin, like U.S. Dollars, can work as currency because its units are fungible and easily transferable. And owning Bitcoins is like owning dollars — they both bestow upon the holder no more and no less than the ability to transfer them. Dollars do allow for physical collectability and display, physical touch, and visual apperception, but this isn’t crucial to, or even a substantial aspect of, the dollar’s status as currency. (Both Bitcoins and dollars can also bestow upon their owners the psychic benefit of knowing that they have a certain amount of value stored — one might get a lot out of knowing that one has a very large bank balance, for example — but they only appreciate that knowledge because it means that the dollars or Bitcoins can be transferred to others in the future. Even the psychic benefit of a large bank balance only exists in virtue of the transfer value of the currency it represents.)

The U.S. Dollar is backed by the full faith and credit of the United States Government, while Bitcoin is not backed by any government. However, a tenable conception of “currency” doesn’t require government backing. The U.S. Dollar would be just as much a currency if it were backed by gold, silver, bronze or tin. Status as a currency does not depend on being backed by a physical thing, trust in a government, or anything else. So long as it is fungible, transferable, and users share the belief that it’s worth something, it can be a currency.

It’s reasonable to argue that Bitcoin isn’t a very useful currency — perhaps because of its volatility, or its (currently) limited ability to handle high transaction volume — but while such arguments critique Bitcoin, they don’t show that it isn’t a currency.

Bitcoin is, in essence, just like any other currency. Its apparati (the network, the wallets, the code, etc.) are, in the ways that matter, analogs of the apparati of fiat currency. And we are better off if we recognize Bitcoin for what it is. What, other than perhaps some tax revenue and marginal protection of the U.S. Dollar or precious metals, do we have to gain from denying this truth?