Tax management through blockchain – will this ever be possible?

In the early days of blockchain technology, there was much excitement about its potential to transform the tax system and the way taxes are collected. In a 2015 survey by the World Economic Forum, 73% of respondents (over 800 business executives) predicted that governments would collect taxes via blockchain by 2023.

Well, that year has come and the prediction has failed. Although there have been several successful blockchain projects in the tax space, the technology has still not gained significant market acceptance. The OECD discussion document Tax Administration 3.0 The Digital Transformation of the Tax Administration from 2020, which sets a vision for the digital transformation of the tax administration for the coming years, barely mentions blockchain among the tools that will contribute to a seamless and frictionless tax collection process in the future.

Is Blockchain for Tax Another Example of the Segway Curse? When the Segway, a two-wheeled, self-balancing electric vehicle was launched, it was hailed as an invention that would change society. The product worked well, but the world wasn’t 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 the 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 for the same fate.

Great vision

Blockchain was hailed as the cure for almost every problem affecting the value added tax (VAT) system in the EU. Every year, EU countries lose billions in VAT revenue due to tax fraud and inadequate tax collection systems. In 2020, the VAT gap (ie the difference between expected and actually collected tax revenue) was estimated at 93 billion euros. Governments have implemented various compliance obligations such as split payment, real-time reporting and mandatory e-invoicing, which improve tax collection but also contribute to the fragmentation of the EU’s single market and increase the cost of doing business.

Another issue that can create tax risk for businesses is the increasing complexity of supply chains. Businesses that do not have enough insight into their entire purchasing and distribution network may be exposed to additional VAT liability if another party in the chain commits fraud and they are unable 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 promoted in the academic literature. The most advanced use case would be to use a distributed ledger to record all VAT-relevant transactions between businesses. These transactions will be validated by the tax authorities in real time, enabling the rapid detection of irregularities and fraudulent activity. Other more limited use cases include the use of distributed ledger technology to keep track of documentation for deliveries of goods within the EU, or to record transactions within the company. In a world full of asymmetric information, imperfect data and increasing information needs from tax authorities, a single incorruptible ledger that records and validates transactions seemed like a very appealing idea. So why has the tax sector failed to embrace blockchain solutions at scale?

Innovation that needs its ecosystem

Breakthrough innovations do not happen in isolation, but instead need complementary products to take hold. Sometimes a product fails not because of an inherent flaw, but because society is unable to properly support it when 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 work successfully.

Blockchains were originally designed as standalone systems with a specific purpose. But any blockchain-based tax solution must be deeply integrated and share data with various business applications that are often used by organizations to manage their activities. Although it is possible to integrate blockchain into a company’s Enterprise Resource Planning (ERP) system to create an immutable platform for storing an organization’s data, such integration is very challenging given the variety of different ERP systems on the market and the limited the number of middleware technologies that can connect ERP systems to different blockchain networks. The integration work can become even more complex if a company uses more than one system.

If blockchain was to be used for actual tax collection (as the World Economic Forum survey predicted), as opposed to just being a vast data store, it would have to support money transfers. Currently, distributed ledgers can only transfer cryptocurrency and tokenized assets, but payments in a fiat currency (including tax transfers) still rely on the traditional financial system. A proper integration of payment facilities will thus be a prerequisite for any blockchain-based tax collection system.

Value in scale

From the tax authority’s perspective, blockchain-based VAT solutions would provide more benefits if they were used for both domestic and cross-border trade. This means that a VAT blockchain project must be developed and managed by more than one country. Participating countries must agree on decision-making procedures, technology standards, service level agreements, system audits and dispute resolution mechanisms.

Various collaborative projects in the area of ​​indirect tax involving several countries have shown that it is a difficult task to achieve international consensus. While countries are generally willing to agree on non-binding recommendations and guidelines, the idea of ​​passing binding laws is far less appealing. The EU countries have not been able to reach an agreement on many reform proposals that tried to harmonize the EU’s VAT system. Even something relatively simple like the concept of a single, EU-wide VAT return was abandoned due to divergent opinions. Since blockchain-based solutions will require consensus on matters that go beyond taxation, the difficulties in coordinating the interests of various stakeholders will be exacerbated.

A solution that needs a problem

Although the creation of a blockchain-based tax reporting or collection infrastructure may never be realized due to a lack of political consensus and high implementation costs, blockchain technology has also seen a very slow uptake among tax departments. Although a shared ledger updated in real time may seem like a good tool for administratively complex handling of transactional tax data, tax departments are not very keen to adopt blockchain to streamline and transform their processes. In contrast, other technologies such as the automation of robotic processes 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 the data they exchange. Blockchain-based systems are not suitable for supporting individual tasks for a single department; they are designed to provide traceable documentation of data exchange across organizational boundaries in a way that neither party can unilaterally manipulate. The use cases for blockchain in a single department are not very clear. A tax department may 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, which prevent 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 worlds: someone must program the distributed ledger and ensure that correct entries are made. Since input must 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, the blockchain is technically correct, but not legally correct.

Finally, there is the element of risk. Since the purpose of tax departments is to ensure compliance and protect the company from tax liability risk, most companies would not consider them the right place to experiment with new technology. Before implementing new technology solutions, tax managers usually want to know how many other companies have tried the innovation and adopted it. As tax departments use data from many different systems, compatibility and interoperability considerations are important when choosing new technology tools.

Conclusion

Although tax administration has become more digital and automated, it still relies on “traditional” technologies and a blockchain-based VAT system is unlikely to emerge 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 often occur in VAT systems, its widespread use in the tax sector is hampered by the challenges of interoperability, standardization and 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 alternative solutions that can achieve the same result 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 organization with which the author is affiliated.