Distributed ledger technology
In the early days of blockchain technology, there was a lot of excitement about its potential to transform the tax system and the way tax is collected. In a 2015 survey by the World Economic Forum, 73% of respondents (over 800 business leaders) predicted governments would be collecting taxes via blockchain by 2023.
Well, that year has arrived, and the prediction has failed to materialise. Although there have been several successful blockchain projects in the area of taxation, the technology still has not gained significant market acceptance. The 2020 OECD discussion document Tax Administration 3.0 The Digital Transformation of the Tax Administration, which sets out a vision for the digital transformation of tax administration for the upcoming years hardly mentions blockchain among the tools that will contribute to seamless and frictionless tax collection process in the future.
Is blockchain for tax another example of the Segway curse? When Segway, a two-wheeled, self-balancing electric vehicle was launched, it was praised as an invention that would change society. The product worked well but the world was not ready for it as potential users struggled with many practical questions (Where can you park it? How do you charge it? Do you use it on roads or sidewalks?). Although Segway’s novelty fascinated many people, there was no compelling need for anyone to buy it, and it remains a marginal invention today. Blockchain for tax may be headed toward the same fate.
Blockchain was hailed as the cure for nearly all problems affecting the value added tax (VAT) system of the European Union. Every year EU countries lose billions in VAT revenues due to tax fraud and inadequate tax collection systems. In 2020, the VAT gap (i.e. the difference between expected and actually collected tax revenue) was estimated at €93 billion. Governments have been implementing various compliance obligations such as split payment, real-time reporting and mandatory e-invoicing, which improve tax collection but at the same time contribute to the fragmentation of the EU single market and increase the cost of doing business.
Another problem that may create tax risks for companies is the growing complexity of supply chains. Businesses that do not have enough visibility into their entire procurement and distribution networks may be exposed to additional VAT liabilities if another party in the chain commits fraud and they are not able to prove that they did not know and could not have known about it.
Several ways to incorporate blockchain into the VAT system have been put forward in the academic literature. The most advanced use case would be to use a distributed ledger to record all VAT-relevant transactions among businesses. These transactions would be validated by the tax administration in real-time, allowing a swift detection of irregularities and fraudulent activity. Other more limited use cases include the use of distributed ledger technology to keep track of documentary evidence for intra-EU supplies of goods, or to record intra-company transactions. In a world full of asymmetric information, imperfect data and growing information needs of the tax administration, a single incorruptible ledger recording and validating transactions seemed a very appealing idea. So, why has the tax sector failed to embrace blockchain solutions on a large scale?
Innovation that needs its ecosystem
Breakthrough innovations do not occur in isolation, but instead need complementary products to take hold. Sometimes a product fails not because of an intrinsic flaw, but because the community is unable to support it appropriately at the time it enters the market. Just as an electric car would be of no use if no charging stations were available, a blockchain-based VAT system would require some complementary components and integrations to operate successfully.
Blockchains were originally designed as standalone systems with a specific purpose. But any blockchain-based tax solution would need to be deeply integrated and share data with various business applications that are commonly used by organisations to manage their activities. While it is possible to integrate blockchain into a company’s enterprise resource planning (ERP) system to create an immutable platform to store an organization’s data, such an integration is very challenging given the multitude of different ERP systems on the market and the limited number of middleware technologies which can connect ERP systems to different blockchain networks. The integration effort can get even more complex if a company uses more than one system.
If blockchain were to be used for actual tax collection (as the World Economic Forum survey predicted), as opposed to just being a large data repository, it would have to support money transfers. Currently, distributed ledgers can only transfer cryptocurrency and tokenised assets, but payments in a fiat currency (including tax remittances) still rely on the traditional financial system. Thus, a proper integration of payment facilities would be a prerequisite for any blockchain-based tax collection system.
Value at scale
From the tax administration perspective, blockchain-based VAT solutions would yield more benefits if they were used for both domestic and cross-border trade. This means that a VAT blockchain project would have to be developed and managed by more than one country. The participating countries would need to agree on decision-making procedures, technology standards, service level agreements, system audits and dispute resolution mechanisms.
Various collaborative projects in the area of indirect taxation involving multiple countries have shown that achieving an international consensus is a difficult task. While countries are generally willing to agree on non-binding recommendations and guidelines, the idea of enacting binding laws is far less appealing. EU countries have failed to reach agreement on many reform proposals that sought to harmonize the EU VAT system. Even something relatively simple like the concept of a single, EU-wide VAT return was abandoned due to diverging opinions. As blockchain-based solutions would require consensus on matters going beyond tax, the difficulty of aligning the interests of various stakeholders would be compounded.
A solution that needs a problem
Although the creation of a blockchain-based tax reporting or collection infrastructure may never materialise due to lack of political consensus and high implementation costs, blockchain technology has seen very slow uptake among tax departments too. Even though a shared ledger updated in real time may seem like a good tool for the administratively complex management of transactional tax data, tax departments are not very keen on adopting blockchain to streamline and transform their processes. In contrast, other technologies like robotic processes automation are gaining significant traction in the tax domain.
The main reason for the relatively low interest in blockchain among tax departments is that the use of distributed ledger technology is generally reasonable when several external parties want to interact and keep track of data that they exchange. Blockchain-based systems are not suited to support individual tasks of a single department; they are designed to provide traceable documentation of data exchanges across organisational boundaries in a way that no party can unilaterally manipulate. The use cases for blockchain in a single department are not very clear. A tax department could consider using blockchain for document management, but the existing tools are already well suited to support this task. Similarly, most existing database management systems have an audit trail and advanced user management systems, preventing data manipulation risks.
Although blockchain applications use validation mechanisms and rely on consensus, they may not always record correct data. Just like any software application, blockchain faces the inherent problem of the interface between the digital and physical world: someone must program the distributed ledger and make sure that proper entries are made. As input needs to be provided by people, what enters the blockchain can be subject to manipulation or error. For example, two related parties may agree to include fictitious transactions or fictitious prices in the ledger. If these entries are validated by the network, blockchain is technically correct but not legally correct.
Finally, there is the risk element. As the purpose of tax departments is to ensure compliance and protect the company from tax liability risks, most companies would not consider them the right place to experiment with new technologies. Before implementing any new technology solutions, tax managers typically want to know how many other companies have tried the innovation and adopted it successfully. As tax departments consume data from many different systems, compatibility and interoperability considerations are important in selecting any new technology tools.
While tax administration has become more digital and automated, it still relies on “traditional” technologies and a blockchain-based VAT system is not likely to appear in the near or distant future. Although blockchain technology has the potential to solve problems related to fragmented information systems, limited visibility of supply chains and real-time data traceability that are commonly encountered in the VAT systems, its widespread adoption in the tax sector is hampered by the challenges of interoperability, standardisation and the lack of the necessary ecosystem. Before embarking on blockchain projects, one should consider what added value a blockchain solution will provide and whether there are any alternative solutions that could achieve the same outcome in a more efficient way.
The opinions expressed in this article are those of the author and do not necessarily reflect the views of any organisations with which the author is affiliated.