Discourse on how to design a blockchain-based income tax systemethereum blockchain tech
Pay As You Earn, henceforth referenced as PAYE, is a tax withholding mechanism currently implemented in the UK, the US and Australia (also called Pay As You Go). Employers are responsible to deduct tax and national insurance contributions before paying their employees.
It is not a bad system. Economies of scale enabled a few payroll providers to become very efficient in dealing with the ultra-boring paperwork. Most employers don’t understand what’s happening under the hood, which is brilliant. It means they can focus on making their business great!
Of course, while the system is not bad, it requires a lot of trust and human bandwidth to stay afloat. I put thought into how a mechanism similar to PAYE could be developed on top of Ethereum and I’ll carve out a feasible solution in this article.
Do note though that I’m strictly discussing income tax and nothing else. There’s a plethora of other categories, such as Capital Gains Tax, Inheritance Tax and Council Tax, which are not covered here.
Say Hello to Sablier
Sablier is a project I recently announced on Twitter. It’s a platform for continuous salaries that gives employees instant access to their earnings. For more details, check out this article, as all we have to understand now is what are Sablier “streams”.
Let’s imagine Alice, an employer, and Bob, an employee that earns $100 a day (inclusive of weekends).
- Alice deposits $3,000 on Sablier.
- Bob works for 5 days.
- Bob has the right but not the obligation to withdraw up to $500 from the stream (100 x 5 days).
- Alice has the right but not the obligation to cancel the stream and withdraw the leftover sum in her wallet, that is, $2,500. If she does this, Bob receives $500 in his wallet.
- If 25 additional days pass and Alice doesn’t cancel the stream, Bob would be able to redeem his salary in full, that is, $3,000.
We consider these streams a primitive in our income tax system.
The Fancy Proposal
Let’s assume the tax brackets for a non-married American citizen for 2019.
The US uses a progressive tax system, which means that the first $9,700 earned after deductions is taxed at 10%, the next $29,774 at 12%, the next $44,724 at 22% and so forth.
Now, we need to make a few assumptions.
- The government has an Ethereum wallet. The simplest option would be something like Gnosis Safe, but they may want to use a Ledger or a Trezor physical wallet.
- The government is willing to accept tax paid in stablecoins (digital dollars issues on Ethereum).
- The stream can have multiple recipients. As of the time of writing this article, this is not a feature of Sablier.
Let’s return to the Alice <> Bob stream we previously explored. Let’s imagine that:
- Bob is not married and has never been
- His only source of income is his job, so that by the end of January he will only have earned $3,000, which falls under the $9,700 tax threshold for 10%
- The stream is created on the 1st of January
- No standard deduction or itemize is applied
The stream would turn into this:
- Alice deposits $3,000 on Sablier and pledges to deduct tax on Bob’s salary.
- Bob works for 5 days.
- Bob has the right but not the obligation to withdraw up to $450. If he does this, $50 is withdrawn to the government wallet.
- Alice has the right but not the obligation to cancel the stream and withdraw the leftover sum in her wallet, that is, $2,500. If she does this, Bob receives $450 and the government $50.
- If 25 additional days pass and Alice doesn’t cancel the stream, Bob would be able to redeem his salary in full, that is, $2,700. The government would receive their 10% share, which is $300.
We can extend this process to future months and switch to a new tax bracket. For example, in April, we may tax Bob 12% instead, because by then Bob will have earned $12,000. This is above the first threshold of $9,700, but it is still below $39,475.
And that was it! Simple, beautiful, progressive taxation on Ethereum.
The really big advantage in using a blockchain income tax is that it brings a significantly lower cost of settlement. The blockchain, in and of itself, becomes your accountant, making timekeeping spreadsheets obsolete.
Companies could deposit an annual salary on Sablier once, earn interest on that and forget about it (if the employee doesn’t leave the company in the meantime).
- Block numbers are just a trustless proxy for time. Different models using time oracles or sidechains could also be used.
- We presumed block numbers are a good-enough solution for governments. It’s close to impossible to accurately predict the exact time of a future block, because mining is a stochastic process. This means that the dates of a fiscal year might “float” by a tiny bit.
- Sometimes, stablecoin prices fluctuate and no, this is not an oxymoron. While some reserve-backed coins such as USDC are more stable, free-market alternatives like DAI saw swings as high as $0.10, both downward and upward.
- Deductions can be tricky. I abstracted them away before to make it easier to showcase the tax flow, but further research is required in finding an optimal solution.
What I love about an income tax on the blockchain is that it’s truly “pay as you earn”, compared to the fiat world, where it’s more like “pay once per month, kind of”.
In the proposal herein, taxes are calculated based on a block time average (which is ~14 seconds on Ethereum). Taxes could be paid at any time of the month when the employee makes a withdrawal, not at the end.