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:
- Tax Reward per unit LUNA: this is used in Updating Tax Rate
- Total mining rewards: the sum of the Tax Rewards and the Seigniorage Rewards, used in Updating Reward Weight.
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.
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