November 28, 2006

Should There Be Taxes In Virtual Reality?

I am apparently a little behind the times, because I was surprised to learn that 1.4 million people currently play an online virtual reality game called Second Life, which basically provides a virtual universe where a person can, in a sense, live a second life.

What's perhaps even more surprising is that within this universe there is a virtual economy, in which a person have a "job" and use their earnings to buy a piece of "land" or a "house" from another person who is playing the game. Even more remarkably, the virtual dollars used in the game can be exchanged for real money and vice versa. A person who wants to live the life of a baron in virtual reality could exchange actual dollars for the virtual money, enter the game and "pay" someone to build him a castle. The builder, who in reality is being paid to do the programming to create a virtual castle, receives the virtual money which can then be exchanged for real money. So real economic transactions are taking place in the virtual world.

Should such transactions be regulated or even taxed? An article (subscription required) from The New Republic asks this question and suggests that since other types of games (think of gambling) are in fact regulated it shouldn't be out of the question. People who play virtual games seem to oppose any such idea - after all, what's the fun of escaping into the virtual world if things like taxes are going to follow you there?

But at least in theory, a virtual economy can become developed enough that it warrants regulation and taxation. Consider the possibility of using investments in the virtual world as tax shelters. Maybe there are a lot of people who want to buy virtual houses, castles, mansions, palaces or whatever crazy things people dream up but cannot create through programming on their own. It might be more than work than a single programmer can do. It might actually require a whole firm of virtual architects and builders. What if I invested in this profitable company and just left my money there... for thirty years. Assume this virtual universe can only expand as more and more people all over the world obtain access to internet connections and can escape from their own dreary realities to the virtual world. That means there may be an expansive business climate in the virtual world for years to come.

Now imagine that during these thirty years my virtual stock in this company paid hansom dividends but I never took them out of the virtual economy (meaning I never exchanged the money for real money). Instead I just kept putting the virtual money back in virtual investments. Only after thirty years do I decide to "sell" my virtual investments and then convert all the virtual dollars to real dollars.

I have just achieved a massive tax shelter. Being able to take some money and put it in investments for years without paying taxes on the interest or profits until you take the money out -- well, that's basically what an Individual Retirement Account (IRA) is for. And remember, an IRA is LIMITED. You cannot contribute more than $4,000 a year (the limit rises with inflation). It's limited because the tax advantage would be too great if it was not. Normally interest or profits are taxable each year simply because they're income and it would seem fair to tax it just as we tax income from wages. IRAs are the exception and are allegedly designed to increase savings, but in reality they mainly serve to help wealthier people shelter investments from taxes.

Investments in the virtual economy could mean an unlimited tax shelter of this type - if the virtual economy truly takes off. In theory there could also be questions of whether employees at a virtual firm are subject to labor laws, whether or not one can be liable for civil damages for loss of income in the virtual world, and whether or not money could be laundered through virtual investments or banks.

So far now, people will laugh at the very notion of taxing virtual transactions. Let them laugh. "There they go again, trying to find some new crazy way to tax the hell out of us!" But if the virtual economy grows - and it probably will - don't be surprised if this issue comes back up.


At 10:19 AM, Anonymous Aaron Harms said...

Investing in a virtual world would be extremely risky, though. You as a user only have the rights that the designers intend to give you. If you invest all this money in and then suddenly the game designers decide, "Hey, let's emulate life in South America now and take all your assets," or simply become unable to support the game any longer and shut it down. Instead of sheltering your money from taxes, you've lost it completely.


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