Cryptocurrencies have been gaining momentum as the preferred trading and/or investing vehicle across the globe and at home. A report published in the CoinDesk website revealed that WazirX — an Indian cryptocurrency exchange — recorded an annual trading volume of $43 billion in 2021, a whopping 1,735 per cent increase over 2020. Another domestic crypto exchange, CoinSwitch Kuber, registered a 3,500 per cent spike in trading volume during the same period, according to a report published in a leading business daily.

The promise of astronomical returns from cryptos has attracted people across all spheres of the economy. There are about 15-20 million users of cryptos (as of January 2022), according to a Twitter post by WazirX founder Nischal Shetty.

This is interesting as the increased interest in crypto is despite the repeated warnings by the RBI on the extreme volatility in crypto prices, chances of money laundering, and the fear that the government might even ban crypto. The Union Budget was expected to give clarity on the treatment of cryptos.

Budget 2022 defined cryptocurrencies under the broad umbrella of virtual digital assets, including DeFi (decentralised finance) and NFTs (non-fungible tokens). Effective April 1, any gain made on the transfer of such digital assets shall be taxed at a flat 30 per cent along with the applicable surcharge, and no deductions shall be allowed barring the cost of acquisition.

Further, 1 per cent TDS shall be levied against any transaction. Losses made on any transaction are not deductible against any other income. Lastly, if any digital asset is gifted, it shall be taxed at the recipient’s end at the time of any subsequent sale. The government has thus made dealing in such digital assets a speculative activity like lotteries and puzzles.

While investors have welcomed the recognition of cryptos as a digital asset by the government, some experts opine that the tax rate is high, which might hurt and deter small investors.

However, the taxation move should not be a cause of concern for investors. With around 20 million users in India, a tremendous interest in the crypto market (India recorded a 641 per cent spike in investors during 2020-21, as per a Chainalysis report), and no central regulatory body, it becomes imperative first to recognise cryptos as a tradable asset. The move to levy TDS is also welcome as this will ensure that government will be able to track all such transactions, thereby helping monitor money laundering activities.

Further, this high tax rate may deter small, casual and uninformed investors from the market and save them from incurring huge losses. Though the market feared that following the Budget announcement crypto investors would start diverting their funds to equity to enjoy the lower tax benefit, No mass sell-off was seen.

This could be because the Budget has relieved investors of regulatory fears that cryptos would be banned.

Not deterrent enough

While a 30 per cent flat rate of digital tax seems high, it may not be a deterrent as far as big investors are concerned. A look at some of the most traded cryptocurrencies — Bitcoin, Ethereum, Binance Coin, etc., — shows that investors are attracted by the extraordinary profits that can be made by trading in them.

Data from Yahoo Finance shows that in the last seven years, Bitcoin grew at a compound annual growth rate (CAGR) of 115 per cent. Between January 2018 and January 2022, Ethereum and Binance Coin have delivered a CAGR of 30 per cent and 151 per cent, respectively. This high return came despite two major slumps in 2019 and 2021.

Similarly, dogecoin, which began as a joke on Twitter, saw its price soaring after Tesla chief Elon Musk started promoting it. Its price went up from ₹3.93 in March 2021 to ₹21 in October 2021 to ₹11.47 in February 2022.

How does one explain such fancy returns? Research shows that media coverage, celebrity endorsing, FOMO (fear of missing out) factor, price manipulations by “whales” who own 5 per cent of a coin, etc., promote crypto as a transformative asset with endless opportunities, thereby attracting investors who believe that prices will always go up.

In a 2020 paper ‘Is Bitcoin Really Untethered?’, published in the Journal of Finance, professors John Griffin and Amin Shams wrote: “Overall, our findings provide substantial support for the view that price manipulation may be behind substantial distortive effects in cryptocurrencies.”

In a 2019 research paper ‘Sex, Drugs, and Bitcoin: How Much Illegal Activity Is Financed through Cryptocurrencies?’, published in The Review of Financial Studies, authors Sean Foley, Jonathan Karlsen and Talis Putniņs estimate that around one-quarter of Bitcoin users are involved in illegal activities such as drugs and sex, and 46 per cent of Bitcoin transactions were for illegal activities. Thus, the available empirical research shows that non-fundamental factors affect cryptoasset prices.

A survey conducted by the IGM Forum of the University of Chicago finds that 54 per cent of US economists believe that a substantial source of the value of decentralised private cryptocurrencies arises from their convenience for use in illegal activities.

The 30 per cent tax imposed by the India is much lower than by Japan (up to 55 per cent), Germany, France, and Austria (up to 45 per cent), and the US (up to 37 per cent), as per research by The Oddball. Thus, a higher tax rate is warranted if the objective is to discourage speculative crypto trading.

In the US, corporates and financial firms have started accepting crypto payments, and India might soon follow suit.  The 30 per cent tax might be a sufficient deterrent to firms for adopting cryptos as a means of payment or investment. However, as far as traders and investors are concerned, the 30 per cent tax may not deter them from entering the crypto world.

A higher rate would do well given the risk-return profile while trading in cryptos and overall opaqueness concerning how the crypto prices work. Further, given the government’s intention to protect small investors from excessive volatility and cheating, a higher tax rate is much warranted.

Lakshmi is an Assistant Professor of Finance at IFMR GSB, Krea University, and Dash is an Assistant Professor at Gulati Institute of Finance and Taxation (GIFT), Thiruvananthapuram