A February 1 speech by India’s finance minister, Nirmala Sitharaman, outlined some aspirational goals for the Indian Digital economy. Two announcements that stood out were the launch of Digital Rupee, India’s version of a Central Bank Digital Currency (CBDC); and taxation of virtual digital assets.

India will now tax income from transfer of virtual digital assets, such as cryptocurrency and Non-Fungible Tokens (NFTs), at the rate of 30%. Sitharaman also proposed a Tax Deduction at Source (TDS) on payments made at point of transfer of these assets in order to capture the transaction details.

Still unclear

Indian government is yet to finalize their position on legalizing cryptocurrencies. From a complete ban in 2018 to the retraction of that decision in March 2020, their stance on these virtual assets is still not clear. However, they have maintained their view of concern over the use of cryptocurrency for money-laundering, illicit transactions, tax evasion. etc. By taxing crypto transactions, it appears that the government of India wants to disincentivize the fast-growing markets in cryptocurrency and NFTs without directly addressing those concerns.

The taxation of these assets doesn’t imply legalization, though. The legal status of crypto will be clarified in the upcoming “Cryptocurrency and Regulation of Official Digital Currency Bill, 2021.” It does, however, raise some compelling questions. For example, would treating crypto as taxed asset imply that the banks in India, both private and public, can now enter and provide financial services to the crypto industry like they did with gold bonds? Will it deter investors from participating altogether, thereby accomplishing governments’ objective of non-adoption? Or will it just act as a tool to increase government’s tax revenue? It will also be interesting to see if other countries join the bandwagon with taxation of income from these virtual assets.

Digital Rupee

The announcement of Digital Rupee aligns India with 80 other countries which are either in the research, development, pilot or launch phase of CBDCs. It will essentially be a legal tender, like fiat currency, but issued digitally. This announcement was also tied to the government’s concern over virtual currencies. The Reserve Bank of India (RBI) earlier stated that there is a need for Central Banks to address the increasing use of private virtual currencies.

The Digital Rupee, however, is based on an underlying assumption that people will stop transacting in private virtual currencies once a CBDC is in place. This might not necessarily hold true. While the research on reasons for adoption of virtual currencies, like crypto, is still insufficient, the motivation for its use is highly driven by the features of privacy and anonymity. Furthermore, the asset valuation of these currencies is more lucrative for investment. None of this could be assumed for the Digital Rupee. The technological design of Digital Rupee might allow for anonymous transactions (similar to fiat currency), but it is highly unlikely for the Indian government to enable privacy by design.

Sitharaman, in her speech, also highlighted that “digital currency will result in a more efficient and cheaper currency management system.” This claim needs more deliberation. India’s digital payment tech stack is quite mature, so launching a digital currency at retail level won’t increase the efficiency significantly. At wholesale level however, Digital Rupee can reduce settlement risks and increase the speed of settlements in the domestic market thereby making the system much more efficient. For efficiency in global settlements, it is crucial that the countries involved in the transaction have interoperable CBDC infrastructure.

Design and Implementation Considerations

Getting back to digital payments, its widespread adoption in India enabled by the Unified Payment Interface (UPI) has resulted in reduction of cost of transportation, storage and distribution of cash. Even so, the adoption cannot be generalized. Unlike in the US, where financial exclusion is often voluntary on the part of users, in India it often results from lack of access to financial institutions and financial illiteracy. The Jandhan, Aadhar and Mobile Payments (JAM Trinity) tried to address this gap, but the technological divide and low literacy levels complicates the process. What this means is that the method for delivery of Digital Rupee must be carefully designed in order to avoid expanding existing inequalities.

The exact technological design of the Digital Rupee is not out there yet. It is unclear if it is being considered at a wholesale level or retail level. The validation mechanism – whether it will be token based or account based, the distribution mechanism – whether it will be issued and distributed directly by the RBI or through banks, and the underlying technology – whether the ledger will be distributed or centralized, will all have different implications.

The budget speech did mention it to be based on blockchain technology but that seems unlikely. Other concerns aside, implementing CBDCs on blockchain will be a bad idea considering the volume and rate of possible transactions. Since computation and validation of transaction over blockchain is still time consuming, resource intensive and requires a good deal of energy consumption, the objective of efficiency would be difficult to achieve. Nonetheless, the design consideration must factor in security concerns and ensure that the infrastructure is resilient to cyber-attacks.

Everything will remain speculative until RBI comes out with more details about the design and plan for implementation of their Digital Rupee. And it will be interesting to see how, if at all, do they plan to address the above-mentioned gaps.