Policy Considerations Against Taxing Second Life Wealth

Despite its prolific number of small dollar transactions, its technological origins in the video game industry, and the initial perception that the utility derived from the activities in Second Life are somehow distinguishable from those in the real world, an analysis indicates that taxation of the wealth generated inside Second Life is proper appropriate under current U.S. tax law. [see other discussion here] Nevertheless, this article concludes with a few comments about some of the policy reasons not to tax Second Life. It also raises the most pressing issues that this paper failed to explore.

First, note that “Second Life’s grant of property rights to participants seems to have encouraged far greater experimentation and innovation than other virtual worlds. For example, one participant created a video game within the Second Life virtual world and then sold it to a real-world media company, a transaction that would be impossible in most virtual worlds.” Additional interesting and bizarre issues concerning Second Life come to light everyday. Just to list a few: John Edwards’s Second Life presidential campaign headquarters was vandalized with feces and a picture of him in blackface; a virtual riot broke out between members of the French extremist party National Front and Second Life Left Unity, a socialist and anti-capitalist user-group; reports have arisen that certain users have designed a way to override the mobility of other users and virtually rape unconsenting avatars; hundreds of companies from H&R Block and Colwell Banker to Coco-Cola and Mercedes Benz have an active business presence in Second Life; Reuters has a dedicated Second Life News center; gambling activities have become so wide-spread that the FBI is investigating the criminal activities by U.S. citizens. In essence, Second Life is allowing the public to explore the practical boundaries of a three-dimensional version on the Internet.

Perhaps most importantly is that this innovation is developing something as yet unseen in the real world or on the Internet: a viable system for micro-transfers of wealth with transaction costs approaching zero. The importance of this point cannot be overstated. The Linden Dollar has remained steadily at about L$270 per $1, so real people are activity engaging in millions of transactions that are valued as low around $0.0037. Thus far, these transactions have been secure and easy to administrate through electronic accounts where people can, in essence, deposit U.S. Dollars. From YouTube, which has announced that users will receive revenue according to the popularity of the video they post, to Google AdSense, which derives revenue on a per-click basis, the micro-commodification of the Internet is progressing to the point where society can efficiently and profitably trade in fractions of pennies. As a policy matter, the tax law should recognize the economic reality of these micro-transactions while avoiding spoiling the efficiencies created through plummeting transaction costs.

Leanda Lederman, the author of the article Stranger Then Fiction: Taxing Virtual Worlds discussed above, has suggested elsewhere that rather than including Second Life activity in the income tax, “the better result is to tax sales within Second Life (for Lindens).” While this may eventually be the best solution, it also implicates complicated issues as to whether requiring Linden Lab—a company that makes a point to take a hands-off approach—to withhold taxes from or to issue transaction records to millions of users will stunt the growth that Second Life is currently witnessing. This is an important question that merits further analysis.

Finally, and most unfortunately, this paper failed to provide a detailed analysis of how one measures basis in Second Life. Beyond the key operational limitations analyzed above, this is the next most important issue that could drastically affect how to think about the taxation of Second Life. Whether in the context of everyday users claiming hobby losses, active businesses claiming expense deduction, division of profits among in-world partnerships, or taxation of foreign businesses effectively connected to the U.S., the ability to account for basis will dictate what methods of taxation are plausible.

Regardless of these uncertainties and despite the assertions by Congress’s Joint Economic Committee that “taxing transactions that occur within virtual economies . . . would be a mistake,” it clear that it is only a matter of time before the wealth generated in Second Life (or its technological progeny) will be sufficiently great that Congress is passing virtual-world tax legislation and tax lawyers are specializing in the virtual world sections of the Internal Revenue Code. The implications this could have on currently untaxed income like frequent flyer miles and casino chip will have to be left for another paper. From The Taxation of Virtual Worlds: Understanding Theories of Taxation Through an Analysis of the Second Life Economy by Tim Miano.