Proposal to Reduce the Terra Tax Rate to Zero

Disclaimer – I am employed by Terraform Labs (TFL)

Background Context

A core component of the Terra protocol is the Treasury Module, a stabilizing lever that ingests specific data inputs and adjusts to real-time market conditions to regulate miner incentives towards sustainable, long-term growth. One of the primary macroeconomic indicators that the Treasury Module mediates is the tax reward – the income generated from transaction and stability fees on the Terra network, which is subsequently allocated to validators as staking rewards.

The tax reward combined with the seigniorage rewards and total staked LUNA for a given epoch is used to derive the following two values:

The above values are used to compare the relative direction and velocity of the Terra economy and calibrate changes accordingly.

For example, during contractionary cycles in the stablecoin supply, the network bumps the tax rate on transactions across the network to bolster staking rewards while the LUNA supply dilutes to compensate for reduced stablecoin (e.g., UST) demand and the expected per-unit value decrease in LUNA. The on-chain swap fees are also increased to augment cash flows to validators. These features are part of the counter-cyclical design of the Terra protocol to produce stable mining rewards despite exogenous market conditions.

The tax rate is a monetary policy lever that is variable depending on the calculations with the parameters above, which you can find more details about here. It’s a capped fee on stablecoin transactions on the Terra network, on top of the gas fee paid for all transaction compute costs across Terra.

Notably, the tax rate is quoted in SDT and capped at 1 SDT (~$1.39) – meaning that the maximum tax rate per transaction, regardless of transaction size, is 1 SDT during any given epoch. So, even if a transaction of 100 UST has a tax rate of 5%, it will still only be 1 SDT per the 100 UST transaction as defined by the tax cap.

Since Columbus-5 burns all seigniorage, the cash flow from seigniorage available in Columbus-4 and all earlier versions of the Terra protocol is no longer allocated to the Oracle Rewards Pool. Instead, it’s burned. As a result, staking rewards are a combination of the on-chain swap fees and the network tax reward income.

However, the vast bulk of staking rewards currently comes from the on-chain swap fees, which are the fees for swapping Terra stablecoin denominations, known as the “Tobin Tax,” and the spread fee from swaps from stablecoins (i.e., UST) to LUNA and vice versa.

For context, the tax reward income accounts for an infinitesimal portion of the staking rewards in a given epoch, calculated below during the epoch at the time of writing as:

total_staked_luna = 314789294.210928

luna_price = 85

staking_APR = 7.35%

7.35% = oracle_rewards(swap_fee) + tax_rewards + tx_fee

annual_rewards = 7.35 / 100 * total_staked_luna * luna_price

= 7.35 / 100 * 314789294.210928 * $85 / 365 = 5388071.54954 UST per day

tax_rewards per day = 13K~18K UST = 0.3%

Since the tax rewards per day are minuscule relative to the overall staking reward income (i.e., swap fee income), it’s worth performing a cost-benefit analysis of the network tax rate and its implications on other aspects of the Terra economy.

First, let’s examine the benefits of the tax rate.

The tax rate is foremost a monetary policy lever to increase staking rewards via a tax rate hike during contractionary cycles of the stablecoin supply. But as we have illustrated above, the tax rate income relative to the swap fee income is negligible, meaning the argument for its utility as an effective monetary policy lever at the current rate of stablecoin transaction activity is flimsy.

Additionally, the tax rate is utilized as an additional defense mechanism against network spamming (alongside the gas fee appended to every tx), by embedding an additional cost in each stablecoin transaction so that operating bots and spamming blocks with erroneous transactions becomes prohibitively expensive at scale. However, TFL’s position is that the effect of the tax rate on protecting against block spamming and bot operation is negligible, as most of that burden is absorbed by the gas fees anyways.

Examining the costs of the tax rate is where the situation becomes more interesting.

A common thread of feedback from developers building on Terra is the costly nature of deploying contracts to the mainnet due to the tax rate. Particularly for new developers with capital constraints that are attempting to deploy and update multiple contracts on-chain, the tax rate can become a deterrent in building on Terra. A 1 SDT cap may seem negligible on transactions, but stringing together multiple contracts and transactions on top of gas fees can swell to much larger costs over time.

Numerous encounters with new developers on Terra also result in them forwarding feedback about failed transactions due to not supplying the stablecoin tax, adding a further layer of complications to the learning curve of developing on Terra. This also applies to relevant partner integrations, where the issue causes delays in deployment and various user issues after.

In comparison, other major layer one smart contract chains do not have tax rates, as it’s a unique characteristic of the Terra protocol design. This affords those smart contract chains an advantage in the development accessibility of their networks. For Terra, reducing the tax rate to fixed at 0 would offer similar advantages, by alleviating the additional cost burden for developing and deploying contracts on the mainnet beyond the gas fee that is part of every transaction on the network.

As public blockchains are designed to be permissionless and accessible, a fixed tax rate of 0 would be concordant with the underlying ethos of public, open-source crypto networks. The additional hurdle for building on-chain in the form of the tax rate would be removed. Moreover, it would help accelerate both the pace of contract deployment and the onboarding of new developers into the Terra ecosystem, especially those not accustomed to the additional tax rate cost of deploying apps on a public blockchain.

Considering that the tax reward income is negligible anyways, this appears to be a net positive for the Terra economy as long as the tax reward income remains negligibly small relative to the swap fee income.

The remaining item to consider is the defense mechanism the tax rate affords against bots and block spamming.

However, the tax rate mostly functions as a monetary policy lever compared to an anti-spamming or bot deterrent, which is mediated primarily by the network gas fees. By reducing the tax rate to 0, the potentially marginal increase in gas fees over time to compensate for the elimination of the tax rate seems a logically affordable trade-off considering the benefits in development accessibility that it unlocks.

Execution

Proposal to Reduce the Terra Tax Rate to Zero

As a result of the considerations above, this post proposes reducing the Terra transaction tax rate to fixed at 0, rather than its current variable parameter with a cap of 1 SDT.

Should the governance vote pass, the protocol parameter change will go into effect immediately once the voting period concludes.

Of note, like all protocol parameter changes via governance, the tax rate can eventually be reverted back to a non-zero rate to account for any potential externalities induced by the proposed change to a tax rate of 0 – such as gas fees not affording robust enough defenses against transaction spamming or bot activity.

In particular, a non-zero rate could be reinstated via a governance proposal following a situation where the expected income from the tax rewards increases significantly beyond its currently inconsequential number. In this situation, stablecoin transactions on Terra would expand to a state where a meaningful portion of the staking rewards income is derived from tax rewards rather than the vast majority coming from swap fees.

However, the situation where the tax reward income encroaches on the swap fee income share to a meaningful degree seems distant at the current pace. Hence, the trade-off for enhanced developer accessibility in the short-term, which would induce comparatively higher value accrual to the Terra economy relative to any potential downside from the tax rate change, seems the logical choice.

Please allow for open discourse and feedback in the comments below.

15 Likes

Great cost/benefit analysis, definitely agree that for long-term progression of Terra it would be best to do what we can to encourage developers to buidl. Thanks for your work

2 Likes

I suggest removing the tax mechanism completely. Having a tax mechanism means smart contracts that deal with Terra stablecoins will need to introduce additional logics to account for taxes, even if the rate is temporarily set to zero. This adds to complexity for developers and gas cost for users.

Having a tax mechanism also makes it harder for 3rd party wallet apps to integrate Terra stablecoins (Keplr is still not supporting UST transfers; I suspect having to deal with tax is a big reason.)

This is not to mention that the attempt to use tax to stabilize the market will probably be futile anyways, because it can be easily circumvented by simply using a CW20 wrapped version of UST.

12 Likes

Removing the tax mechanism completely is a net positive for everyone. I definitely agree with Larry.

3 Likes

What unintended consequences would that have? Would already existing contracts that have to account for the tax have to be rewritten? I assume they are making a call to find out what the current Tax Rate is. If we remove treasury/v1beta1/tax_rate, those contracts will fail won’t they? We create another set of issues that way.

8 Likes

Agreed that removing the tax mechanism completely is a benefit in the long term.

However, short term as @somethingelse mentioned, such removal will introduce breaking issues for smart contracts and protocols that currently query the chain for the tax rate. Most notably is Terraswap and/or Astroport contracts with their deduct_tax function and by extension any protocols that utilize them.

Not to mention, the work and testing that would need to go into removing the tax mechanism are most likely non-trivial. As the tax mechanism is currently a core part of Terra’s mechanics, removing it would require a coordinated migration, similar to the one from Columbus-4 to Columbus-5. All of this results in a much longer timeline to execute.

With that, the current proposal to set the tax rate to 0 is probably the quickest and best intermediary solution that provides the majority of the benefits while ensuring that no compatibility issues will be introduced post-change. And the tax mechanism can be removed in a larger and more coordinated change, perhaps during the migration to the next major iteration of the Terra chain.

(realized you are probably aware of all of this. just wanted to post it here for visibility for others as well :heart:)

12 Likes

And even though the tax mechanism would still exist after this proposal, since the tax rate will be set to 0 and the tax for a stablecoin tx is calculated as min(tax_rate,tax_cap), protocols and any third-party provider (wallets etc.) looking to support chain now wouldn’t need to take the tax into account or deal with it at all since the final tax value for the tx will now always be 0 post-change.

reference:

5 Likes

Yup, agree with @tansawit, better to stick with initial proposal for the time being, its the cleanest immediate solution we have to developers issues. This buys TFL time to sort out how to best remove tax from the Treasury module in the safest manner possible.

2 Likes

I agree with these changes. It makes the protocol leaner and more inviting. Newcomers do not need to calculate tax anymore. The stability fee revenue is virtually worthless compared to the daily Terra economy.

The proposed change will effectively render the treasury module useless for now. Seigniorage was done away with, and now stability fees.

Should we ever need the treasury module again to fill the community pool, etc., it is better that the treasury mechanism stay around, at least for a little while.

One thing to note:
I’ve been hearing some confusion in the community around fees. To be clear, the Tobin tax for stablecoin market swaps and the spread fee will still be in effect. The tax rate and tax cap do not have anything to do with the Tobin tax or spread fee.

The stability fee in question is a fee on any transaction involving any Terra stablecoin (wallet transfers, payments, etc.) excluding market swaps (Terra<>Terra, Terra<>Luna). Sending Luna has never incurred any fees other than gas. Although this fee is referred to as the stability fee, its parameters are the “tax rate” and “tax cap.”

For more information on fees, see Fees on Terra | Terra Docs

1 Like

How are we going to avoid transaction spam without a tax?

2 Likes

Agree with both points from you and @tansawit, and as you’re aware, removing the tax mechanism completely will likely have to come with the next major software upgrade.

1 Like

Gas fees mostly absorb this burden compared to the tax rate.

1 Like

I’m in support for 0 tax rate. Would greatly benefit transactions where stable coins are moved multiple times in a single tx.

This can be done in next hard fork via SoftwareUpgradeProposal, and making tax rate zero has same effect with removing tax mechanism completely.

Contracts don’t need to care about the tax computation from the proposal passed and tax rate be zero at next epoch.

1 Like

Proposal: Terra Station

2 Likes

Fantastic. The only ridiculous thing on Terra is gonna fucking gone

1 Like

Thank you. Much appreciated.

Thank you.

I agree with the proposal of setting tax to zero for now. But long term I think the tax module should remain. I think that Luna stakers and holders take on a lot of risk so they need to be compensated even in the future when there are not a large community pool burns to replentish the staking rewards.

Having a tax which is separate from the gas fee is also smart. Gas fees are a function of network congestion. Taxes are a function of economic optimization to provide for the public good of the Terra ecosystem (ensuring the peg of UST and the value of Luna)

I like the economics of Terra compared with Ethereum and Solana and other networks. That is why Terra is so great.

2 Likes

Love this idea. I absolutely support setting the Terra Tax Rate to Zero (“0”), while retaining the right to increase the Tax Rate until further notice. Having such a tool may prove beneficial in the future.

Thank you, @TheIntern for providing such a great breakdown to articulate this proposal. I support this proposal and have submitted my vote accordingly.