On May 2, President Biden’s Council of Economic Advisers (CEA) released a statement describing a proposed Digital Asset Mining Excise (DAME) tax. The proposal would impose a tax on cryptomining equal to 30 percent of the electricity used in this activity. In outlining this proposal, the CEA displayed a great deal of ignorance about energy usage, bitcoin, and economic policy.
For starters, we should dispense with the term cryptomining. Bitcoin miners are the only people engaged in what the CEA deems cryptomining. The proposed rule is a tax on bitcoin mining.
What is bitcoin mining?
The bitcoin network allows people to send the digital asset known as bitcoin to one another without any trusted third-party serving as an intermediary. These transactions are recorded on a digital ledger known as a blockchain. When one person wants to send bitcoin to another person, the transaction is broadcast to the network. “Miners” then compete to add blocks of these transactions to the ledger.
The mining process entails passing information about the block of transactions through a cryptographic hashing algorithm to generate an output of fixed-length. The first miner to find an output below a particular threshold value broadcasts its solution to the rest of the network. Other miners verify the solution, add the block of transactions to the blockchain, and start work on the next block of transactions. Although it is difficult to find an output below a particular threshold, it is easy to verify. This allows for decentralized maintenance of the ledger. Rather than relying on one individual or entity to maintain the ledger, the ledger is updated through the consensus of those on the network.
Producing an appropriate hash and, hence, adding a block to the blockchain is random. Miners are essentially guessing solutions until one is found. They use specialized machines designed to guess solutions quickly. Since it is random, it is impossible to know ahead of time which miner will find the next block. The faster a machine can guess, the better the odds of success. But greater computational power is no guarantee of success.
Miners have an incentive to maintain the ledger. Successfully mining a block of transactions comes with a block reward of newly issued bitcoin, and any transaction fees offered by users. The block reward is currently 6.25 bitcoin, which is worth roughly $175,000. (Eventually, around the year 2040, the block reward will cease and miners will only receive transaction fees. At that point, the supply of bitcoin will be fixed.)
Bitcoin mining is computationally intensive. But this computational intensity has a purpose. By making the mining process random, the settlement of bitcoin transactions is resistant to censorship. Since the next successful miner cannot be known ahead of time, there is no single party that gets to determine whether a transaction is valid, no individual or entity that can be threatened or punished to prevent adding a transaction to the ledger, and no single point of failure.
Bitcoin mining makes it possible to engage in electronic peer-to-peer transactions similar to the physical exchange of cash; to trade without the permission of some trusted third party. It is particularly valuable for people living under authoritarian regimes or under governments that impose strict capital controls.
Why does the CEA want to tax bitcoin mining?
Given the computational intensity involved in bitcoin mining, a number of people have expressed concerns about its environmental impact. According to the CEA, the DAME tax is motivated by the fact that bitcoin miners “do not have to pay for the full cost they impose on others, in the form of local environmental pollution, higher energy prices, and the impacts of increased greenhouse gas emissions on the climate.” They argue that imposing the tax will force bitcoin miners to internalize these costs.
In other words, the CEA is making an externality argument. While bitcoin mining benefits miners, the CEA says it imposes an additional cost — a negative externality — on third parties that miners do not take into account when deciding how much to mine. If so, miners will tend to mine too much and a tax on mining might be used to discourage them from doing so.
The CEA claims the externality comes in the form of an environmental cost. Bitcoin miners require electricity to operate, and the generation of electricity creates environmental costs.
Problems with the CEA’s argument
The CEA’s argument fails on a number of counts. Consider first the externality. The careful reader will note that the source of the environmental cost is electricity generation, not bitcoin mining. If generating electricity imposes costs on third parties, then the externality argument implies that a tax should be placed on electricity generation. Taxing a particular type of electricity-using activity does not provide an incentive to reduce electricity. It provides an incentive to switch from the taxed electricity-using activity to other, untaxed, electricity-using activities.
The CEA implicitly assumes that a reduction in electricity used by bitcoin mining is a reduction in electricity generated. Even ignoring the prospect of switching from taxed to untaxed electricity-using activities, that’s not true. A lot of electricity production is wasted: the electricity is produced, but isn’t used. To the extent that bitcoin miners use electricity that would otherwise be wasted, reducing bitcoin mining will not reduce electricity generation. That’s unfortunate, since there is no social cost of mining bitcoin with wasted energy.
In some cases, there is even a social benefit to mining bitcoin with wasted energy. For example, stranded natural gas is typically burned, emitting methane in the process. Currently, people are purchasing this stranded natural gas and using it to generate electricity to power bitcoin miners. In doing so, they are limiting harmful methane emissions associated with flaring natural gas. In these cases, bitcoin mining generates a positive externality. Applying the CEA’s logic, this type of activity should be subsidized — not taxed.
In places like Texas, bitcoin mining is used as a way to balance the electrical grid. Bitcoin miners run when electricity usage (and therefore the price of electricity) is low. When electricity costs are high, the miners turn off and allow for other uses. The result is a more stable and predictable supply of electricity for ordinary users — another positive externality.
The ability of bitcoin mining to stabilize electricity supply can also be used to make green energy more effective, which the CEA fails to appreciate. Windmills and solar panels are capable of generating electricity, but they are intermittent sources: if the wind isn’t blowing or the sun isn’t shining, no electricity is generated. Furthermore, if the timing of electricity use does not line up with the times when the wind is blowing or the sun is shining, then some of the energy produced using green methods is wasted. This can make it hard to justify using these technologies to generate electricity at scale. By serving as a buyer of last resort, bitcoin mining can create the conditions under which these technologies can be used at scale to produce electricity — still another positive externality.
More generally, the CEA ignores the fact that all electricity is not generated from the same source. Windmills, natural gas, coal, and the natural flow of moving water can all be used to generate electricity. Each of these sources, however, produces a different degree of environmental costs in the production of electricity. By taxing a particular use case of electricity, the tax treats the environmental costs as identical across different methods of generating electricity.
This point is especially important when considering the global effects of the DAME tax. The DAME tax would make mining prohibitively expensive in the United States. By discouraging bitcoin mining in the US, the DAME tax would make bitcoin mining more profitable elsewhere. As a result, bitcoin mining would relocate, likely to places where electricity generation has significantly higher environmental costs than in the US. In other words, the DAME tax would likely increase global emissions on net.
Overall, the CEA’s discussion of the DAME tax proposal is disappointing. The CEA seems to be ignorant of bitcoin and the process by which energy is produced and consumed. And its economic analysis is flawed. Externalities associated with electricity generation are not unique to bitcoin mining and, hence, do not justify a tax on bitcoin mining. If such a tax is warranted, it is warranted on electricity generation — and only to the extent that the particular type of electricity generation is characterized by a negative externality. The CEA’s argument would result in a failure on an introductory microeconomics exam. One expects better from a team of professional economists.
This article, CEA Deserves an F on Bitcoin Mining Tax Analysis, was originally published by the American Institute for Economic Research and appears here with permission. Please support their efforts.