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Taxing Blockchain Staking Rewards (Part 2 of 3)

Author: Tailored Accounts 

Two Sources of Staking Rewards 

To get a better understanding of the different sources of staking rewards and the role these sources play at different stages in the development cycle of a blockchain it is necessary to provide an overall picture of a blockchain’s funding model. This work will focus on the Cardano blockchain. According to a recent study conducted by Finders.au, Australia ranks number one for Cardano blockchain adoption in the world.

As represented in Figure 1 below, staking rewards for both delegators and stake pool operators are taken from two sources: the Reserve and Transaction fees. 

The Reserve is made up of 13.8B tokens. These tokens only come into existence when they are minted. Specifically, every epoch (a duration of 5 days), all the transaction fees from every transaction from all blocks produced during that epoch are put into a virtual 'pot'. Additionally, a fixed percentage, ρ, of the remaining ADA (ADA is the Cardano platform’s native cryptocurrency) reserves is added to that pot. Then a certain percentage, τ, of the pot is sent to the treasury, the rest is used as epoch rewards. 

This mechanism ensures that in the beginning, when the number of transactions is low, because users are just starting to build their business on Cardano, the portion of rewards taken from the reserves is high. This provides a great incentive for early adopters to move quickly and benefit from the initial rewards. Over time, as transaction volume increases, the additional fees compensate for dwindling reserves. This mechanism ensures that available rewards are predictable and change gradually. There will be no sudden 'jumps' comparable to bitcoin halving events every four years. Instead, the fixed percentage taken from remaining reserves every epoch guarantees a smooth exponential decline.
Figure 1: The Cardano Funding Model

The rate of monetary expansion that results from minting new tokens from the reserve is set as one of the parameters of the Cardano protocol.  Higher values of monetary expansion mean higher rewards for everybody and a treasury that fills faster. But higher values of monetary expansion also result in faster reserve depletion and the dilution of a token’s value relative to the value of the underlying asset (the issue of dilution is dealt with in the next section). It is certainly important, especially at the beginning, to pay high rewards and incentivise early adopters. But it is also important to provide a long-term perspective for all stakeholders incentivising their commitment to growing the network and its capital appreciation.

Cardano will never run out of reserves, instead there will be an exponential decay. Currently, however, approximately 0.22% of the reserve goes into the virtual pot and a 100% of these minted tokens are distributed as staking rewards. The treasury, which provides funding for the development of Layer 2 decentralised applications is funded entirely from transaction fees and taxes on block production. This funding distribution has now been in place for almost two years. Based on the current rate of monetary expansion, it is expected that the reserve will reach its ‘half-life’ in a little more than two to three years. In other words, every four to five years, half of the remaining reserve will be used. This is close to the 'bitcoin half-life' of circa four years, so Cardano reserves will deplete at about the same rate as bitcoin reserves.

It is worth noting here that it took Bitcoin around eight years to reach its peak of maximum adoption and price. Likewise, it makes sense to expect Cardano adoption and capital growth, along with transaction volume and exchange rate, to increase sufficiently over the next 5-6 years to more than make up for the decrease of monetary expansion during that time. It is also expected, contingent on the growth of the blockchain industry, that resulting tax from the capital appreciation will also provide a large revenue stream for Governments. 

Although the main source of staking rewards is a token reserve that forms the basis of an incentive mechanism crucial to the development and operation of a decentralised PoS blockchain, the next article will expand on why it is wrong to think of staking rewards that have as their source newly minted tokens resulting from inflationary monetary policy as taxable income at the point of distribution.