Blockchain and corruption, tax evasion, and money laundering
Fraud /frɔːd/: wrongful or criminal deception intended to result in financial or personal gain
The evils of corruption, tax evasion, and money laundering are driven by greed, perpetrators hiding legitimate but taxable income, the proceeds of crime, and the ill-gotten gains of fraud, bribes, and secret commissions. The direct victims of these crimes are employers, clients, legitimate businesses, and government, tax, and revenue agencies. The indirect victims are the communities or jurisdictions in which these acts are perpetrated and to which revenue is owed.
The cost of hiding money is significant. Estimates run to the billions of dollars worldwide. According to the Organisation for Economic Co-operation and Development (OECD), the cost of corruption is more than 5% of the global gross domestic product (GDP). Overall, corruption reduces efficiency and increases inequality [182, 183, p. 2]. Blockchain technology can help reduce the incidence of corruption, fraud, tax evasion, and money laundering by securely managing identity in permissionless networks.
There are two clear divisions in the ways in which blockchain technology can be used as discussed in Chapter 2: permissioned or permissionless. Bitcoin operates across a permissionless network, in which the users interact with each other pseudonymously. Users’ identities are protected by private and public key access. The bitcoin blockchain and other permissionless cryptocurrency networks enable corruption, tax evasion, and money laundering. Meanwhile, a permissioned network is one where users have identified themselves or provided their identity to a central authority to create a user account. It is this latter type of blockchain network that appeals to business and governments for its capacity to report transactions seamlessly to regulators. We explore the potential use of permissioned blockchain networks to enable secure and authenticated exchanges. Together with digital identities, users on a permissioned network can securely conduct business online, while seamlessly reporting activity to regulators. With a lot of business and government records and transactions transitioning to online networks, the adoption of blockchain technology to manage permissions and ledgers, and to report to regulators is a next logical step in the evolution of the internet. This has been made possible by cloud-based applications and the increased processing power and interconnectivity of hand-held and portable devices.
Before the advent and adoption of computing technology in the mid- to late-20th Century, business and government records were maintained manually. Records and ledgers were kept in hardcopy format. This system was exposed to risk of error and destruction, and it was time-consuming and expensive for agencies to cross-check or share data. Failure to manage record retention policies and the administration of document access can result in significant running costs, and may have legal ramifications [184].
Businesses and governments all over the world started using computers to manage record-keeping from the late 1960s onwards. By the 1980s, networking computers within organisations enabled the sharing and transfer of data between nodes and departments. Users in these private networks did not need to hide their identity from each other because they were participating in the same joint endeavour. It was the advent of the internet and interconnectivity between competing or unknown nodes and users that gave rise to the need to create user identities and passwords.
Since the early 1990s, the misuse of computers and unauthorised access to or manipulation of data held on computers has posed a significant problem for society and for all economies [185, p. 23]. Most of these risks are difficult to contain, because the technology that enables them continues to develop [186].
Formal online relationships are created when banks, employers, businesses, and government ask participants in their online networks to create a user identity and password. In these relationships, it is not just financial security that is at risk. The collection of personal information and confidential data requires further levels of security to protect against privacy breaches and fraud. It is these formal online relationships that this chapter addresses. The sorts of activities that could benefit from blockchain technology are: verification, movement of assets, ownership, and identities.
If adopted by government, banks, and businesses, Blockchain can streamline online exchanges, and reduce corruption, mistakes, fraud, and tax evasion. This is achievable because blockchain technology is the most sophisticated tracking system yet to be developed [187, p. 589]. The first supply chain systems improved visibility and control on goods and products as they moved from point A to point B. The same methodology has applied to tracking movement of money and assets. Tracing money and its substitutes represents a significant element in any effort to identify and recover proceeds of crimes or undeclared income and profits. However, the old concepts and technologies no longer support today’s complex global digitised assets and money.
The goal with Blockchain is to create networks for participants to set rules governing public ledger and smart contracts. If all users can see and verify transactions, the risk of any one player avoiding their private or civic obligations is removed. A key component of any strategy to address corruption, tax evasion, and money laundering is ensuring that no one player can hide from their obligations. With the removal of cash from our economies on the rise, it is important that online transactions be made visible and verifiable.
In January 2017, police in Boston found US$20 million dollars under the mattress of a Brazilian man suspected of laundering money. Prosecutors alleged that Cleber Rene Rizerio Rocha, age 28, was hiding the proceeds of a multi-billion-dollar fraud. For five years, Rocha and his associates had been promoting their company, TelexFree Inc., as a telecom company [188]. Initially, its main source of income was a US$20 per annum subscription fee for internet services. This business model looked innocent enough. However, TelexFree’s first brush with infamy came soon after its inception, when it became apparent that its logo was exactly the same as the logo for the World Badminton Championships. TelexFree had plagiarised the design.
As the company grew, it moved to inviting investors to buy shares in the apparently successful business. Participants would buy shares for about US$1400 a piece, and were allegedly promised fast, double-digit returns. They received incentives for bringing in family and friends. According the Federal Bureau of Investigation TelexFree aggressively marketed its services by recruiting thousands of ‘promoters’ to post ads for the product on the internet. Each promoter was required to ‘buy in’ to TelexFree at a certain price, after which they were compensated by TelexFree, under a complex compensation structure, on a weekly basis so long as they posted ads for TelexFree’s VoIP service on the internet.
The ad-posting requirements were a meaningless exercise, in which promoters cut and pasted ads into various classified ad sites provided by TelexFree, which were already saturated with ads posted by earlier participants. According to evidence filed by victims of the scam, TelexFree derived only a fraction of its revenue from sales of its services—less than 1% of TelexFree’s hundreds of millions of dollars in revenue over the previous two years. The overwhelming majority of its revenue came from new investors buying into the scheme. TelexFree was able to pay the returns it had promised only to its existing promoters by bringing in money from newly recruited promoters. By 2014, it was clear that Rocha and his associates has been running an international Ponzi Scheme, using money taken from an ever-growing network of small investors to pay off earlier participants.
Ponzi Schemes are not new. Their history stretches back to the late 1800s. Named after Boston businessman Charles Ponzi [189, p. 871], the original operator of a ‘robbing Peter to pay Paul’ scam was a New York confidence trickster named William Miller. In 1899, Miller stole US$1 million from investors with a promise that he knew how companies operated and promising returns on investment of 520% [190].
At the heart of all Ponzi Schemes is a betrayal of trust. A client or investor gives their money to an investment manager. The fund manager is charged with investing their client’s money in a certain way, for example, in exchange for bitcoin or stocks. The investment manager owes fiduciary duties to the client with respect to that money. Fiduciary duties are special obligations that not only ensure the health of the relationship between investor and trustee, but also are a significant cornerstone in our financial industry. Fiduciary law is not something that can be easily diluted or renegotiated. It is a complex social phenomenon with a rich history founded in law, psychology, anthropology, and religion. The fiduciary relationship underpins the morality of how we do business. Unfortunately, history has also taught us that many a fiduciary has turned predator.
What the case of Rocha’s mattress reveals is that the fact and scale of his fraud were not the headline-grabbing part of the story—it was the cash hidden in his mattress. Most news services led with this feature. Hiding US$20 million in cash is not a simple proposition. The most popular denomination for money launderers is the US$100 bill. Smaller bills are too many in number to conceal and carry. If each of Rocha’s bills were no bigger than US$100 in value, he had to hide at least 200,000 notes, removing them from circulation.
Despite the difficulty of concealing these numbers, cash remains very popular in criminal activity because it is one of the last remaining stores of value that is anonymous and untraceable. According to Australia’s Minister for Revenue and Financial Services Kelly O’Dwyer, there are three times as many AU$100 notes in circulation in Australia as there are AU$5 notes. In the USA, studies have shown that the overwhelming majority of all US$100 notes are located either in Miami or on the border of Canada and Mexico [191, p. 2].
Ponzi Schemes and corporate scams are not the only activities that rely on cash to hide ill-gotten gains from authorities. Shadow economies, such as Mexico’s informal economy discussed in Chapter 4, (also known as ‘black markets’) take many forms. The activities of shadow economies generally fall within two broad classifications:
1 Trade in illicit goods or services, which is paid for in cash so that the business dealing itself remains undetected;
2 Otherwise legitimate business that deals in undeclared cash in order either to fraudulently claim welfare or to avoid paying either income or consumer tax.
Both of these types of activity are treated as criminal offences in most developed and many developing nations [192, p. 119].
Cash-in-hand economies cost nations billions of dollars in lost revenue every year. In 2015, the Australian Government put more than 21,000 small businesses on written notice that their accounts would be scrutinised in the ensuing year for evidence of undeclared cash transactions with customers and suppliers. Typically, owners of these businesses deal directly with their customers and can avoid taxes by under-reporting their income through understating cash receipts and/or overstating their business expenses. It is the first time in a decade that the bureau has updated its estimate of the ‘non-observed economy’. The Australian Bureau of Statistics has estimated that the nation’s ‘underground production’—otherwise known as the cash economy—is worth 1.5% per cent of GDP or about US$24 billion a year [193].
Money laundering is the process of converting money received illegitimately by rendering its source undetectable to authorities. The most popular method is to gamble the money in a casino. The process is very simple. A criminal who needs to launder US$500,000 earned from selling illicit drugs will simply buy US$500,000 worth of betting chips at a casino. He or she places US$250,000 of the amount on a bet that has a 50% chance of success. The other US$250,000 is placed on the other side of the bet. Whichever side of the bet wins, the gambler will be placed in the pre-bet position. The chips are sold back to the casino and the funds are no longer the proceeds of crime, but have become casino winnings.
Reverse money laundering is a process that disguises a legitimate source of funds that are to be used for illegal purposes [194]. It is usually perpetrated for one of three purposes:
1 Financing illicit activity (for example, terrorism) [195];
2 Legitimate business conducted by criminal organisations that have invested which need to withdraw legitimate funds from official circulation;
3 Unaccounted cash received that is not included in official financial reporting which could be used to evade taxes and pay bribes or secret commissions [196].
5.4 Trade in illicit goods and counterfeiting
Trafficking in illicit goods is a generic term used to describe all types of illicit trade. It includes such practices as counterfeiting (trademark infringements), piracy (copyright infringements), smuggling of legitimate products, and tax evasion. Selling fake or counterfeit products as the real thing is one aspect of this crime; so is selling genuine goods on the black market to avoid paying taxes. By avoiding regulatory controls, the criminals behind these activities typically peddle often-dangerous goods with a complete disregard for the health and safety of consumers. The phenomenon has grown to an unprecedented level, posing tremendous risks to society and the global economy [197].
All levels of society are impacted by trafficking in illicit goods. For example, counterfeiting harms businesses that produce and sell legitimate products, governments lose tax revenue from products manufactured or sold on the black market, and consumers are at risk from substandard products. As an example of the enormous costs involved in illicit goods, the annual trade in illegal drugs is worth 0.4% of the GDP or about US$6.5 billion a year, in Australia alone [193, 198].
Corruption is the receipt of money, gifts, and opportunities in exchange for favourable rulings and treatment by government authorities. It presents itself in the abuse of public or private office for personal gain. It includes acts of bribery, embezzlement, nepotism, or state capture. It is often associated with and reinforced by other illegal practices, such as bid rigging, fraud, or money laundering.
It is a problem all over the world, and in many cases consists of generous cash and electronic payments to a decision-maker. Examples might include a multinational company that pays a bribe to win a public contract or tender to build a highway or bridge, despite its submission of a substandard proposal, or the appointment by an official of a friend or family member to a position of office, despite their lack of qualification or experience for the position [199, p. 1].
According to the OECD, the costs of corruption for economic, political, and social development are becoming increasingly evident. However, many of the most convincing arguments in support of the fight against corruption are little known to the public and remain unused in political debates [182]. The victims of corruption are the weak and vulnerable.
Tax evasion is the illegal activity of avoiding tax payment to a government or a jurisdiction. It creates most of the ‘shadow’ economy that is hidden from official view. It occurs when people abuse tax and superannuation systems through intentional and dishonest behaviour, with the aim of obtaining a financial benefit. It encompasses a broad spectrum of non-compliant activity which can result in criminal sanctions, such as fines or imprisonment. This criminal behaviour ranges from deliberate offences, such as failing to report cash wages in order to avoid tax and receive welfare payments, to the use of complex offshore secrecy arrangements to evade tax. It is estimated that tax evasion in excess of 5.1% of the world’s GDP occurs as a result of shadow economy activities in every state in the world [200].
Tax evasion can take many forms and, apart from offenders becoming increasingly innovative, law enforcements also become increasingly innovative, turning to technologies such as big data to stop tax evasion. In 2016, the Australian tax office decided to start cracking down on tax offenders by investing in data analysis of social media platforms such as Twitter or Facebook and combining that with other data sources to which they have access. The Australian Tax Office (ATO) collects data from a wide range of public and private services, including immigration, motor registries, stock exchange, banks, health insurers, and many more. By combining these with public data from social media, the ATO is capable of easily tracking tax offenders. As a result, in November 2016 the ATO discovered a family who reported a total income of AU$140,000. Although quite substantial, it was obviously not enough to send their three children to private schools at a cost of AU$75,000 and to book business class flights for the entire family three times a year and a holiday in the Canadian ski resort of Whistler. The ATO was able to link the data from their Facebook account, showing images of the family while skiing in Whistler, with immigration data as well as other data sources [201]. However, tax evasion is not the only way families or corporations are trying to avoid paying taxes.
A tax haven is a financial product or jurisdiction that offers more attractive tax rates specifically for the purposes of attracting business. The first tax havens offered competitive tax rates to attract not just the registration of the business into that jurisdiction, but also the means or operation of the business itself. For example, at the end of the 19th century, the State of Delaware sought to lure businesses away from New York and Chicago. In order to make Delaware a more attractive place to do business, the government imposed a much lower corporate tax rate than the other states in the USA. This strategy was very successful. However, in the past 30 years, the internet, telecommunications, and the changing nature of business have meant that many businesses have incorporated in Delaware without actually moving the business to the registration address. These businesses are using the address of registration merely as a ‘booking centre’ [202, p. 1013].
These booking centres are big business. It is estimated that more than a million American companies and trusts are registered in Delaware. More than 285,000 businesses are estimated to be registered at 1209 Orange St, Wilmington [203], one of Delaware’s most popular registration addresses. Its customers include Apple, Google, Facebook, Berkshire Hathaway, Walmart, five of the Clinton foundations, and the Trump Hotels Partnership. Delaware’s earnings from its attractive corporate tax rate account for a quarter of its income.
Although these Delaware company registrations are transparent, they are not without controversy. Neighbouring states—such as Pennsylvania—publicly complain that they are missing out on vital revenue from local businesses that extract minerals from Pennsylvania’s soils, but avoid paying corporate tax in Pennsylvania by incorporating in Delaware.
Secret tax havens present a problem on a much bigger scale than their transparent counterparts. There are more than 30 countries in the world offering corporate and trust registration services. These include Switzerland, the Cayman Islands, the Bahamas, the Cook Islands, British Virgin Islands, and the Netherlands Antilles. Secret tax havens require the involvement of trusted third parties who are located in jurisdictions known to have low tax rates. These third parties are lawyers, accountants, trustees, nominees, and other agents. Central to the operation of these tax havens are the bank secrecy laws [204]. For example, income earned in Canada might be sent via a series of complicated transactions to the Cook Islands and then repatriated to Canada disguised as loans.
Most tax havens have the support of their legislature to ensure that very strict secrecy laws protect customers from international inquiry—including trustees in bankruptcy, subpoenas, court orders, and judgments. These rules do not necessarily mean that the parliaments of these countries intend to assist in the concealment of fraudulent activity [205, 206]. However, this is clearly an unfortunate by-product of the business culture. Those non-disclosure laws affect the booking centres and the banks where the funds are hidden in untraceable, numbered bank accounts. For this reason, it is difficult to estimate the extent of the wealth hidden in these locations. However, thanks to a leak by an anonymous employee to a German newspaper, one of the biggest tax haven operations in the world was exposed in 2016. The Panama Papers revealed that law firm Mossack Fonseca employed more than 600 employees in 45 countries assisting its clients to hide their wealth in Panama bank accounts. The sheer scale of their activities reveals a complex network of hidden wealth and shady practices to mask illegal activity and launder the ill-gotten gains of business people and criminals all over the world. Some commentators suggest that this revelation is just the tip of a tax haven iceberg [207, p. 131].
Welfare fraud is a controversial problem that has accompanied the growth of the welfare state. The modern welfare state was designed as a comprehensive system through which governments provide support for all citizens in need, with a view to eliminating poverty and enhancing health and well-being [208]. Welfare systems frequently entail a wide range of living allowances paid to elderly people, unemployed people, those with intellectual and physical disabilities, sole parents, and students. Support also normally includes a range of partial, indirect, or in-kind government-funded benefits, such as child support payments and free or discounted medical services and childcare. In recent years, entitlement to welfare has also been extended to refugees and asylum seekers.
The welfare state has been the target of numerous criticisms. One standard critique is that it attracts fraud. There can certainly be little doubt that early benefit systems were highly vulnerable to abuse [209, 210]. It was not without justification that the terms ‘dole bludger’ and ‘welfare queen’ became part of the social and political discourse in many countries in the 1970s and 1980s.
Anecdotes about people feigning illness or disability, living on welfare while avoiding work, or collecting benefits while working, became a standard part of social gossip [211]. The right to apply for welfare and the availability of money created intrinsic temptations for people to attempt to obtain benefits fraudulently [212].
Welfare is usually organised around two main criteria—universal eligibility or means testing. Under universal eligibility, all persons fitting general criteria receive a benefit. For example, anyone over a specified age receives an old age pension. Conversely, means testing involves a second set of criteria related to income and assets. Recipients must meet a criterion, such as age, and also have income and assets below a specified threshold. Means testing is the primary form of welfare provision in Australia. It appears to be less costly, by reducing the number of recipients, and appears to be fairer in providing income only to those in genuine need. Alleged disadvantages of means testing include the requirement for a more complex bureaucracy and the creation of temptations for some applicants to understate or hide income and assets [212].
Attempts to obtain benefits illegally used to be difficult to discover, if one looks at the statistics for Australia’s federal welfare agency Centrelink (located in the Department of Human Services portfolio). In 2008–9, Centrelink distributed approximately AU$86.6 billion to 6.8 million customers, including AU$10.4 million in individual entitlements, across 140 benefit types on behalf of 27 government departments and agencies. It approved 2.7 million new claims, operated over 1000 service delivery centres, employed just under 28,000 staff and made over six billion transactions on customer records [213].
A major concern for these agencies is ensuring that the recipient is genuinely entitled to receive the payment they applied for and have received. With six billion transactions to monitor, this used to be difficult to control. However, with the advent of big data analytics, governments have been given a new tool to crack down on welfare fraud and to ensure ‘payment integrity’. As a result, there are an increasing number of prosecutions brought each year against fraudulent recipients of welfare [210]. Indeed, many of these anti-fraud measures have been criticised as stigmatising welfare recipients and generating ‘a punitive approach to income support’ that is overly reliant on criminal prosecutions [211]. However, a particularly problematic type of welfare fraud occurs when recipients of cash income for gainful employment hide those payments in order to conceal the fact that they are working (and therefore not entitled to welfare).
5.9 Traditional approaches to closing the tax gap
The USA has an Annual Tax Gap that exceeds US$400 billion [214].1 The tax gap is the difference between the amount of tax revenue that should be collected and the amount actually collected by the Internal Revenue Service. There are tax gaps in every developed country in the world. This gap exists in large part due to the bank secrecy laws of tax havens and the shadow activities of corrupt individuals and other money-launderers. In recent years, countries such as the USA which are losing out on much-needed revenue have entered into memoranda of understanding and treaties with a number of countries in an effort to address the shortfall. In addition to these measures, the US Department of Justice and the Federal Reserve targeted US branches of foreign banks to increase compliance with the USA [204].
In an attempt to protect the US securities market, US courts have begun to employ measures aimed at circumventing bank secrecy laws. The trend towards recognising the USA’s interest in the integrity of its securities markets is reflected in US court orders requiring bank customers to waive bank secrecy laws. Courts justify these orders by reasoning that secrecy laws exist for the protection of customers, not for the protection of the foreign states’ public interest [204].
The OECD has recommended three initiatives for a global approach to closing the tax gap: international tax rules, tax treaties, and transparency. There is the Model Tax Convention on Income and on Capital, which forms the basis for negotiation of the more than 3000 existing bilateral tax treaties in the world, and there are the Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations and providing regulators with sufficient information to conduct audits [215]. In recent years, the OECD has grown increasingly concerned with the effectiveness of current transfer pricing documentation guidance. In particular with the proliferation of diverse, local, transfer pricing, documentation rules, taxpayers have expressed concern that the compliance costs for transfer pricing to meet each jurisdiction’s specific requirements are becoming oppressive. Tax authorities have, however, expressed the view that transfer-pricing documentation currently being prepared is insufficiently informative for their risk assessment and tax enforcement needs, and provides an incomplete picture of taxpayers’ global operations. As such, the OECD has reiterated the core overarching objectives of encouraging taxpayers to make informed assessments of their obligations before they file their income tax returns.
Meanwhile, the OECD’s Forum on Harmful Tax Practices has built support for fair competition and minimised tax-induced distortions, with more than 40 regimes identified over time as potentially harmful, all of which have been abolished or modified. The engine of harmful tax practices is a lack of transparency. Although blockchain is not the cure-all for the tax system, it could be applied in a number of areas to reduce the administrative burden and collect tax at a lower cost, helping to narrow the tax gap. Blockchain could cut costs and add value within a business, between businesses, between businesses and consumers, and between businesses and governments. There is a need for experimentation and courage to try different applications, and Blockchain can provide real-time and secure information about provenance, traceability, and transparency of transactions.
In order to address welfare fraud, the Australian government has a number of methods of detection. Anti-fraud measures adopted overseas and in Australia include: data-matching between government agencies; stepped-up identity verification checks; covert surveillance and video recording; stepped-up investigations, with greater use of forensic accounting and site visits; increased prosecutions; increased recoveries through debt collection strategies and asset forfeiture; and public tip-off lines [210]. Most of these measures can be automated by monitoring bank accounts as well as social media activities. However, when wages are received in cash it is easy to conceal those payments by using cash for day-to-day expenses (for example). If cash is removed from the economy generally, this sort of fraudulent activity becomes much harder.
5.10 Removing cash from circulation
In December 2016, the Australian Government announced its plan to establish a task force to explore the role of cash in black market economies. In particular, it will look at phasing out the circulation of AU$100 and AU$50 notes, in a bid to reclaim billions of dollars in lost revenue and to reduce welfare fraud. It has been suggested that large notes are being used to pay undeclared income, avoid goods and services tax (GST), and launder the ill-gotten gains of illicit activities. The Australian Government is also contemplating restrictions on the maximum size of cash purchases.
These ideas are not new. At least a dozen other countries are exploring similar measures, with Sweden introducing legislation requiring cash registers to transmit all transaction records directly to its Treasury.
Economists argue that most of the large denomination bills in countries all over the world are not in circulation because they are either being hoarded or hidden [216]. The hoarders fear economic or political collapse and the impact on currency. However, it is the facilitation of crime that wreaks the most havoc on the circulation of cash.
Paper currency, especially large notes such as the US$100 bill or the 500 euro bill, facilitate crime: racketeering, extortion, money laundering, drug and human trafficking, the corruption of public officials, and terrorism. There are substitutes for cash—cryptocurrencies, uncut diamonds, gold coins, prepaid cards—but, for many kinds of criminal transactions, cash is still king [217]. Nowhere in the world has the push to reduce cash as a means to tackle tax avoidance and corruption been received with so much enthusiasm as in India. Driving the push towards less cash is the amount of tax revenue lost each year to corruption, welfare fraud, counterfeiting, money laundering, and other black-market activities that are enabled by large denomination bills.
In November 2016, Prime Minister Narendra Modi dealt a blow to what has been described as India’s endemic corruption with a surprise move to ban the country’s largest currency bills. The ban was intended to curb the flow of counterfeit money and to target terrorist organisations that rely on unaccounted-for cash. It was also expected to help the government clean up a system that has relied on cash to pay bribes and avoid taxes [218]. But the announcement, made on national television in both Hindi and English, led to an immediate upheaval in the country. Abolishing the current version of the 500 and 1000 rupee notes, worth about US$8 and US$15, effectively removed 80% of the currency in circulation [219].
In addition, the European Central Bank announced that, from 2018, all large euro notes would be removed from circulation [220]. However, by September 2017 some individuals, most probably criminals, had already tried to get rid of these notes. A blocked sewer pipe beneath a UBS bank and nearby bistros in Switzerland revealed tens of thousands of high denomination euro notes that had been flushed down numerous toilets. A waiter in the Pizzeria du Molard told a local newspaper that the restaurant had called the police after the men’s toilets became blocked up. On investigating the cause of the blockage, staff found dozens of shredded €500 in the bathroom’s plumbing. Some of the notes had been shredded and investigators reported that they seemed to have originated from a safe deposit box in Geneva. Although destroying bank notes is not an offence in Switzerland, the local police confirmed that the case warranted further investigation. The disposal of these notes may be linked to illegal activities and money laundering, although at the time of writing the exact cause was still unclear.
All of these attempts to address the tax gaps in various jurisdictions suffer from one universal barrier to their implementation and success: there is no incentive for tax avoiders and their facilitators to cooperate. In the words of a Caribbean banking official [221], ‘demand for disclosure is a call for extermination’ [222, 223]. It is time for a new approach.
5.11 Using the blockchain to close the tax gap
The Blockchain’s advantage over traditional online payment systems is its cash-like completeness and immutability. With permissioned access to payment networks and systems, it is possible to link transactions to tax obligations and ensure receipt of revenue by tax authorities. Similar to cash, the only way to return transfers conducted on a blockchain is to undertake a new transfer. The Blockchain’s immutability means that there is no analogous danger of counterfeit. Although notes and coins can be replicated by sophisticated criminals, there is no equivalent process or deception available on Blockchain networks.
The Ukraine is exploring the use of the Blockchain to curtail corruption, particularly when selling government assets. Besides the immutable nature of the public asset ledger, the Ukraine Finance Minister, Oleksandr Danilyuk, has pointed out that a major advantage of the blockchain-based system is that it completely eliminates the possibility of administrative interference during bidding. He promised that, ‘new online auctions will be fully transparent and open’, with an eAuction that would not only fit into the existing infrastructure, but also reduce paper work [201].
By using blockchain technology, it is possible to monitor all electronic payments and transactions, including transfers to other jurisdictions. The technology underpinning and enabling the Blockchain can validate users and transactions, eliminate double spending, and improve the speed and security of transactions. One of the significant costs that can also be addressed on the blockchain is streamlining compliance with ‘Know Your Customer’ (KYC) and ‘Anti-Money Laundering’ (AML) obligations. In addition to identifying and verifying users, the blockchain can track the movement of assets. Each transaction is unique and cryptocurrencies themselves act in the same way as marked bills: from the moment of creation, it is possible to follow the trail of any single unit or file as it moves within the network. As such, it is important to understand that, despite what some people believe, Bitcoin is not anonymous; it is only pseudo-anonymous. This means that, with sufficient data at hand, something that is not too difficult to obtain in today’s big data era, one could start to see patterns in the transactions and as such de-anonymise the data. By linking public keys to real identities, law enforcers could identify every link in the blockchain network. However, big data analytics does not solve the challenge created by so-called ‘mixers’, online platforms developed to conceal whose funds were sent to whom. These mixers enable situations where Alice and Bob both sends funds to Eve, and then Eve sends funds to Carl and Dennis; it’s not obvious whether Alice’s money flowed to Carl or to Dennis. If this is done at a scale of thousands of transactions simultaneously, it becomes even more confusing.
Nevertheless, to achieve these two apparently competing aims (de-identifying parties to legitimate transactions, while revealing the identities of parties to ones that are illegitimate or suspicious), smart contracts can be coded to monitor and report transactions on the network. Permissionless (public) blockchains allow users to control the degree of privacy with which they deal with others on the network. In the case of permissioned systems that include regulators, the system can still allow private transactions, with code that identifies certain types of conduct. This autonomy and control allow users to choose the level of privacy they want in their interactions, depending on the type of network [65, p. 42]. Parties to legitimate exchanges will have their privacy protected, whereas those who attempt to engage in illegal or suspicious transactions can be prevented from doing so until they defend what they are about to do. If that justification requires that they reveal their identity, this would be the cost of using the network for those types of transactions.
Although there remains a risk that some players will structure their transactions so as to mask or hide the total value or purpose of their payments, it is important to remember that this is a problem that already exists on a massive scale. The benefit of using an online system with built-in trust protocols is that more people can participate.
A 2013 study into the traceability of bitcoin transactions suggested that vulnerabilities in the blockchain network could be exploited to assist in the identification of specific transactions [224]. It is this potential for discovery that has led to innovations which add a secure transport layer on top of bitcoin (for example, ZCash). Providing confidentiality in a public blockchain brings distributed ledgers culturally into line with traditional financial privacy protocols enjoyed with physical cash. Financial privacy and even secrecy can be defensible. It is not always necessary for governments and regulators to know about all transactions. The types of transactions that need to be reported are already understood in current systems. What cryptocurrency can allow for is the trusted online exchange of value for things, absent or unsecured, expensive or slow third parties.
As long as there are legitimate users on the system, the passage and use of bitcoin can be revealed, particularly at the moment when the owner of the bitcoin wants to spend or convert it into goods or services [225]. A study by Small, and the possibilities offered by its author, are particularly important in light of bitcoin’s growing popularity as a tax haven. Regulators need to apply resources to examining how this network can be exploited in a way that ensures that all participants on the network are using it for legitimate purposes.
How can blockchain technology achieve where other anti-corruption systems have failed? Very simply, through trust. As the bitcoin blockchain has proven, distributed trustless consensus is the Blockchain’s major breakthrough. By deploying one of a number of zero knowledge proof mechanisms, the Blockchain can record and report to all users how participants are conducting themselves. To motivate users to behave well and to report on the good (or bad) behaviour of others, it is possible to give value to all transactions on a network. As such, many distributed networks apply game theory to incentivise good behaviour. Value could be represented by tokens or a crypto-coin. The tokens/coins could be converted to fiat money or fund data storage capacity or computational power on the blockchain (for example). In order to fund these rewards (or tokens), all or certain types of transactions on the network could be taxed. To ensure that there is no build-up of tokens or values in any one block or at any one time, the tokens created for tax purposes would be applied to the rewards within the same block. For every successful and trustworthy transaction, participants would receive a trustworthiness rating that increases with regular use.
It would be easy to include in this model a special rating that applies to users who have verified their identity with a regulator, thereby satisfying the KYC/AML requirements (as discussed in Chapter 3). Indeed, there could be a higher reward token for those who register with or identify themselves to the regulator. In this way, if any users have not received a KYC/AML proof, then all other users would be on notice about this and would restrict or completely preclude transactions with that participant. The idea that use of a blockchain network can be funded by participants, and that consensus mechanisms can be incentivised, is the reason why the bitcoin blockchain has been so successful. In addition to meeting regulatory requirements, the blockchain has the potential to monitor the financial sources of governments and politicians, and even the banks accounts run by committees to re-elect political leaders.
Underpinning this hypothetical solution to digital money laundering is the notion of trust. Trustless systems require that everyone can trust the network to behave as it should, regardless of the intentions of any particular party, which could be arbitrarily malicious. In the same way that coded messages can safely pass through enemy hands and an email can be encrypted and then safely sent through an untrusted channel, so too can the blockchain allow participants to rely on its consensus mechanisms. At any given time, every player on the ledger can observe all transactions, making it almost impossible to hide or manipulate transactions.
Similarly, cryptography answers the needs of trust of safety, because we can require transactions to have cryptographic signatures. If everyone in the system is able to verify cryptographic signatures and refuses to accept payment without one, the trust of safety is achieved [226].
Corruption corrodes public trust, undermines the rule of law, and ultimately delegitimises the state [182]. Rules and regulations are circumvented by bribes, public budget control is undermined by illicit money flows, and political critics and the media are silenced through bribes forcing out democratic systems of checks and balances. If basic public services are not delivered to citizens due to corruption, the state eventually loses its credibility and legitimacy. Removing large denomination bills from circulation is an essential step towards combatting shadow economies, corruption, and money laundering, and ultimately closing the tax gap. The challenge for regulators will be to harness the power of Blockchain to trace digital transactions. Permissioned blockchains can ensure that users are reporting income and meeting their tax obligations. These blockchains could also interact with other blockchains, so that agencies and departments can automate cross-checking of related transactions. Indeed, running discrete blockchains to manage different functions would ensure that the scale of each network remains manageable and would reduce the incidence of blockchain bloat.
Thinking back to the TelexFree scam and the US$20 million hidden inside Mr Rocha’s mattress, one can see how a trust rating system would have quickly undone his Ponzi Scheme. Ponzi Schemes rely on new money to pay out previous investors. The fraud lies in the promise that payments are being made from profits generated by the business in which shareholders or customers have invested. With a transparent distributed ledger, it would be possible to see that new money into the scheme was being used to pay investors. This would indicate to other participants on the network that there is no successful business scheme generating profits and the payment of dividends. And with all cash removed from the economy, Mr Rocha’s bed filled with US$100 bills would be worthless.
Note
1 According to the US Internal Revenue Service (IRS), the average Annual Tax Gap for 2008–2010 is estimated to be US$458 billion, compared with US$450 billion for tax year 2006. IRS enforcement activities and late payments resulted in an additional US$52 billion in tax paid, reducing the net tax gap for the 2008–2010 period to US$406 billion per year. The voluntary compliance rate is now estimated at 81.7% compared with the prior estimated rate of 83.1%. After accounting for enforcement and late payments, the net compliance rate is 83.7%.