October 10, 2022

Analysis: Ethereum’s Modern Monetary Policy

Ether was net deflationary through the weekend, eliminating over a week's worth of net issuance in 2 days.

Explanation

Each time you transact on the Ethereum blockchain, you have to pay a "gas fee" denominated in its native currency ether (ETH). Ethereum automatically destroys, or burns, a significant portion of the gas fees paid.

Meanwhile, Ethereum constantly emits ETH to the decentralized network of people running software on their computers to maintain the blockchain. Those people are called validators or stakers, and it isn't hard to join them if you want to earn an ETH-denominated yield.

The burn/issuance mechanism is such that, during times of low network use, ETH is a slightly inflationary asset as more ETH is emitted than burned, whereas during times of high network use, ETH is a slightly deflationary asset as more ETH is burned than emitted.

It’s a dynamic but autonomous, instantaneous (not reactive) monetary policy, and it's extraordinary. Imagine if the global supply of U.S. dollars could be similarly governed.

Taxes

What does this have to do with taxes? As I wrote last week, stakers still don't know how they are taxed on on the emissions they receive.

It's worth considering that, due to Ethereum's burn/issuance mechanism, each new ETH that the blockchain credits to a staker can economically look like a shift of (1) some smaller amount of ETH away from others, if the system is net inflationary, (2) exactly the same amount of ETH away from others, if the system is neither net inflationary nor net deflationary, or (3) a greater amount of ETH away from others, if the system is net deflationary.

On top of that, ETH's U.S. dollar value can fluctuate a lot, and emissions to stakers are virtually constant.

So, from a policy perspective, it isn't obvious what the "right way" to tax staking rewards is, or whether a right way even exists.

This article was written by Jason Schwartz, a tax partner and co-head of the Digital Assets and Blockchain Practice at Fried, Frank, Harris, Shriver & Jacobson LLP.

Premium Content

Available only to Premium subscribers.

 

Tags