Dilution and True Economic Gain from Cryptocurrency Block Rewards

Abstract

Dilution is the loss experienced by incumbent owners upon the creation of new ownership units (such as shares or tokens). Although a number of ad hoc patches to the U.S. tax code typically provide incumbents with some form of tax allowance for their loss, there appears to be no unified theory of accounting for dilution – for tax or any other purposes. When additions to one’s balance from newly created units are viewed as an income realization event, whereas dilution is not, net income is systematically overstated. The resulting over-taxation could be a serious hurdle to the adoption of proof-of-stake cryptocurrencies, which rely on token creation by incumbent owners as an integral part of network maintenance. In this short article we quantify the potential for over-taxation — defined herein as the excess of taxable income under a strict realization approach over true economic income — for a real-world taxpayer holding cryptocurrency tokens.

Our example taxpayer is a Tezos staker — a token holder who acquires new Tezos cryptocurrency tokens by participating in the maintenance of the Tezos network. We present the pros and cons of different methods of accounting for dilution when the cryptocurrency’s aggregate network value, the taxpayer’s ownership balance, and the rate at which dilution happens are all time-varying. We conclude that the acquisition of those tokens should not be an income realization event, although any of the methods we propose would be preferable to an approach of strict realization that ignores dilution entirely. Tax policy aside, the methods we develop to quantify the economic value lost to dilution are independently interesting to investors and other finance and accounting practitioners.

Keywords: Tezos, Proof of Stake, Bitcoin, Cryptocurrency, Taxation, Income Tax, Dilution, Block Rewards, Implied Dilution, Depletion

JEL Classification: K34, E4, E42, G28, H2, H20, H21, H24, H25, K00, L51