A Stake to the Heart

Why Uncle Sam Loves Proof of Stake

Starting in 2018, we have seen the rise of a great number of coins using proof of stake (PoS) in their consensus mechanism. Among these are EOS, Tron, Cosmos, Tezos, and many others, with total represented market cap being measured in the billions of dollars.

At first glance, the attraction of holding these coins is clear. By staking your coins, you are earning anywhere from 4 to 15% annually on your holdings. But, where is the money coming from? Of course, the money is coming from the only place it can come from: from other people who are not staking their coins.

Staking rewards are created through inflation. If everyone holding a given crypto-asset is staking all their coins, then everyone gets (out of thin air) a new amount of coins each period exactly proportional to their existing ownership. So, at the end of every period, everyone’s ownership stake in the asset is exactly the same as it was previously.

On the other hand, if only a fraction of coins are staked, then the stakers will indeed be made richer, at the expense of the holders who do not stake. The non-stakers’ ownership of the total pie gets diluted by the new coins issued to the stakers.

For a concrete example, take a fictional coin called PIE. The staking rewards on PIE are 10% per year. At the beginning of the year, there are 100 coins in total, and 10 holders, each holding 10 coins. Let’s say half the holders stake their coins for one year, while the other half do not. At the end of a year, each of the stakers will have earned an additional coin, giving 5 stakers with 11 coins each and 5 non-stakers still with 10 each. The total supply has been inflated by 5% to 105 total coins. Each staker, who previously owned 10% of the PIE, now owns 11/105 = 10.47% of the PIE. Each non-staker has at the same time had his stake reduced to 10/105 = 9.52% of the PIE. Note that while the stakers were earning a 10% nominal yield, their real return was a more modest 4.7%, balanced precisely by the losses in ownership of the non-stakers.

So, clearly, if you’re going to hold one of these coins, you need to be a staker, otherwise you are going to be diluted continually by others who do stake. So, if we follow this to its inevitable conclusion, the long term stable equilibrium is that almost everyone will stake. (And even assuming no changes in ownership or behavior, the percentage of non-stakers naturally gets smaller every year, simply due to the dilution.)

But, if everyone stakes, then there is no return to be provided by the non-stakers, there is just inflation, which does not provide a real return. Of course there may always be a few irrational actors who choose not to stake. But in general, the staking yield should be thought of more as the penalty rate for non-stakers than as the reward rate for stakers. So, this means as a holder of PoS coins, you are in a position of needing to do work and/or put coins at risk, but you don’t really get paid for it. But, let’s say we accept that burden just as the cost of holding PIE since it’s such an awesome coin. Well, actually, it’s much worse than that.

You see, the IRS (and likely many other tax agencies worldwide), sees that 10% nominal yield you’re getting, and says, “Hey, that looks like income to me. I’ll take my slice of PIE, please. By the way, I need that in dollars.” Despite you not getting any richer, the IRS is still happy to make you poorer.

Assume, for sake of simplicity, that all PIE-holders are US taxpayers paying a 35% marginal tax rate, and of course, pay all their taxes. Since everyone is staking, and they’re getting paid 10% nominal yield, they will owe 3.5% of the initial market cap in taxes (or~3% of the end-of-year post-inflation market cap). Where will they get the money to pay that? Well, they’ll likely have to sell some PIE, putting downward pressure on the price. This is what happens when you effectively have an annual wealth tax on an unproductive asset. Well, how bad is this? It’s only 3.5%, right?

As a thought experiment, let’s assume the IRS decided they’d actually take PIE in payment of taxes, rather than requiring dollars, and they’re willing to just sit on it (and of course stake their own coins too). The below table shows what happens to the ownership base of PIE over time. The tax authorities own over half the coins by year 22. (At least, hopefully, the roads will be nice.)

This thought experiment is actually the best case scenario, because you have a committed holder in the IRS, who never sells. And over time, they actually take less and less from the other holders because they already own most of the coins. It takes them until year 70 to get to 90%. But the reality is worse, because the IRS doesn’t actually want your PIE, so you’ve got to find new buyers to sell to every year, otherwise there is an ongoing price drag on the coin. (Likely there’s a price impact regardless, otherwise the new marginal buyers would have already bought at the existing price.)

The higher the staking yield, the worse the problem. At a 20% staking yield, it takes the IRS only 12 years to get half the coins. At a 5% yield, it takes them a leisurely 41 years to get half… but they still get there.

Now, there is some question as to whether these staking payments are actually taxable. In the securities world, companies may sometimes issue dividends which consist of new shares of the same stock, (a “stock dividend.”) This happens, for instance, when a company does a stock split, issuing 1 additional share of stock for every existing share that is held. These are not taxable, for exactly the reason that there is no economic gain from the transaction.

The problem is, staking payments are not stock dividends, either in law or in practice. In fact, they are fundamentally different from dividends, because you actually have to do something to receive them. Namely, you have to engage in the business of staking your coins, in the hopes of making a profit at the expense of non-stakers, or at minimum, for the purpose of avoiding a loss. While the Congress (with sufficient lobbying) might well get around to making PoS rewards free of tax… I wouldn’t hold my breath.

In conclusion, with PoS coins:

  • You need to do work and/or risk your coins.
  • You’re not compensated for this with a real return, except to the extent other holders are irrational/lazy and fail to stake.
  • After-tax, you actually experience a negative real return because of taxation on nominal phantom income.

Disclaimer: I am not an attorney or tax accountant. This article should NOT be taken as tax advice. As always, consult your own tax professional.