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.

The Relationship Between Price & Utility (For Beginners)

2. The Creation of Price Through Weighted Preferences

Previous analysis indicates that it is possible to maximize relative utility in certain circumstances with no information other than the disparately ranked preference sets of two individuals. Taking that conclusion as true, one can begin to understand the relationship between utility—measured in terms of wealth, consumption, and income­—and exchange. From a neoclassical perspective, exchange is possible when individuals recognize that they have disparate preference sets, each individual controls the means to satisfy the other’s need, and both recognize the other’s control. In the discussion of controlled and uncontrolled means above, control meant that an individual could realize utility from one half of a binary need, and which half depended entirely on which was higher ranked. In the context of exchange, control also is determined from the perspective of a second individual. That is, A controls the means to satisfy B’s preference if for some binary need, B will realize the utility from one half of the need according to some arrangement within A’s preference set.

For example, suppose that A can get apples from a tree but that B has no way to get apples other than through A’s consent. Suppose further that B has a preference set of getting an apple from A > not getting an apple from A. If A has a preference set of giving apples > not giving apples, then A will give B an apple and maximize B’s utility. However, if A prefers not giving apples > giving apples, then the lower half of B’s binary preference set will be met. In either case, B will realize one of the preferences from his binary need, and which one he realizes turns exclusively on A’s preference set. Thus, A controls the means to satisfy his own need (getting and giving v. not getting and giving) as well as B’s need (receiving v. not receiving). Notice that if A’s preference is entirely independent of anything that B can affect, then receiving an apple is an uncontrolled need with respect to B. However, if B can affect A’s preference set such that A’s preference to give an apple can turn on B’s effects, then receiving an apple is a controlled preference with respect to B. In that case, giving or not giving is a controlled need with respect to A, and receiving or not receiving is a controlled need with respect to B. In this situation exchange is possible.

Recall that, so long as fulfilling one individual’s preference set does not rearrange another’s preference set, then all thing being equal, no matter where those preferences lay in A and B’s larger preference set, if one must satisfy a need for both A and B, then it will always maximize utility to satisfy the higher ranked preference of both A and B for any pair of disparately ranked preferences (presuming no transaction costs). More clearly, when one has to satisfy some preference of both A and B, utility is always maximized by giving A one apple and B one banana with respective preference sets (1, 3) and (4, 1). This principle also holds when A controls the means to satisfy one of B’s needs and B controls the means to satisfy one of A’s needs. That is, so long as fulfilling one individual’s preference set does rearrange another’s preference set, then all thing being equal, no matter where those preferences lay in A and B’s larger preference set, it will always maximize utility for A to satisfy B’s preference and for B to satisfy A’s preference when those preferences are disparately ranked by A and B. Thus, when A controls one banana, B controls one apple, and A and B have respective preference sets of (1, 3) & (4, 1), ceteris paribus, utility is always maximized when A and B exchange their apple and banana. This is the abstracted version of what economic means when it refers to “gains from trade.”

Notice however, that if A controls one banana and B controls nothing, then once again, there is no way to tell if a transfer would be utility maximizing, even on a relative scale. Similarly, if A controls three bananas and B controls one apple, while both A and B would harvest utility when exchanging one for one, two for one, or three for one as compared to not exchanging at all, there is no way to tell which outcome is maximizes total utility because there is no common unit to measure A and B’s respective utility. Nevertheless, when A controls three bananas and B controls one apple, receiving one or two bananas for one apple increases utility for B, giving one banana for one apple increases utility for A, and giving two bananas for one apple decreases utility for A as compared to one trade. So if A and B cannot divide the apple or bananas into pieces, then one and only one exchange will take place. However, there is a point between A giving one banana and A giving two bananas where A continues to increase more utility than she loses when receiving an apple (i.e. she maintains positive diminishing returns). If A and B were able to divide their fruit into pieces, then given A and B’s preference sets, B could successfully insistent he receive up to 1.2 bananas in exchange for his apple, leaving A with one apple and 1.8 bananas. This outcome allows both A and B to realize the greatest amount of utility given each other’s preference sets, and is referred to as a Nash Equilibrium.

These principals give rise to a theory of price. In this case, A has bananas but prefers apples, making her a banana seller and an apple buyer. Because A prefers apples to bananas at a ratio of 1/3, the price of one of A’s bananas is anything greater than 1/3 of an apple. Thus, for any individual, the minimum offering price is the ratio of any two weighted preferences within a preference cluster where the numerator is the need that the individual wants satisfied through another’s control and the denominator is the controlled need the individual is offering to satisfy another’s need. Conversely, the price of B’s apple is anything greater than 1/4 of a banana, or to leave things in terms of A, B is a banana buyer and an apple seller, which means than B is willing to pay anything less than an apple for a 1/4 of a banana. Therefore, there is a price range in the banana market of 1/4 – 1 apples, and both A and B will harvest utility from any sale in this price range. As noted, given A and B’s preferences, a sale of 1 apple for 1.2 bananas maximizes utility for both A and B, so the final market price of banana will be 5/6 apples, which properly falls within the price range. From The Taxation of Virtual Worlds: Understanding Theories of Taxation Through an Analysis of the Second Life Economy by Tim Miano.

Inter-Virtual-World-Exchange: Contracts, Regulation, and Taxation

". . . Anshe Chung Studios, a company that emerged from inside a virtual world by reinvestment of value created within virtual worlds, is preparing to launch a virtual financial market, financial products and a set of services that are going to allow direct capital flow and investment across virtual world boundaries. No real money trades will be involved. This step will be the first of many in the creation of an open, cross platform Metaverse economy that transcends individual virtual worlds.

"Some virtual worlds like Second Life, Entropia Universe, and IMVU have demonstrated the enormous economic potential that exists when key sectors of a virtual world economy such as content creation, trade, banking and services are privatized. This has lead to a boom in each of these worlds that has yet to be matched by any other economy, real or virtual," says founder Ailin Graef a.k.a. Anshe Chung. "Now the time is right to go further and link these exciting spaces together, to begin with the creation of the global Metaverse."

"In the real world, the flow of capital and investment across national borders has always been a driving force for political progress, economic reforms and the emergence of a global conscience and economy", adds Guni Graef, CEO. "We believe that allowing residents in a virtual world, no matter which one they have chosen to live in, to easily diversify their portfolio of virtual investments into other virtual worlds is going to lead to a paradigm shift. At ACS we are convinced that once capital is flowing freely, people, goods and services will follow and eventually we will see incentive and pressure for the emergence of open tools and standards. It is our vision that one day even traveling across virtual worlds and taking your belongings with you should become as easy as a mouseclick." The new financial market will allow Second Life residents to invest their Linden Dollars directly in ventures such as banks, malls or biospheres in Entropia Universe while those who earned their fortunes in Entropia Dollars will be able to easily diversify their investments into assets such as Second Life virtual land funds, virtual game development businesses or the IMVU fashion design industry. . . ." From Anshe Chung Studios to Link Virtual World Economies.
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". . . [This] clearing and exchange system would be fully governed by private contract with a single company. It is, in essence, a proprietary system with some unspecified exposure to "real world" public regulation. This is by contrast to standard international economics in which the relation of private agreements and public regulations is relatively clear (or at least we have a sense as to how to resolve debates over who regulates what). How the evolution of the online economy will interface with the mainstream economy—and economic regulation—is still an open question.

Despite the hype from some quarters that the online economy is its own entity, separate from the regulatory dinosaurs of the "real" world, I would not sell the mainstream regulators short. How the interactions of old economy regulators and new economy companies evolve will play an important role in determining the success of private attempts at financial market-construction. Moreover, whether this one particular attempt to build a “virtual” financial transfer system will take hold or if it will be overtaken by another privately-run system is a question that will be left to the market. . . ." From Brave New World(s): From International Finance to Inter-Virtual World Finance.
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". . . Unlike poker chips, which are heavily regulated by the casinos that use them as units of exchange, Second Life—and the Internet in general—is more or less a free-form marketplace. “Although Zarin acquired tangible property, the chips, the chips were not property in the relevant tax sense because they were only a ‘local’ medium of exchange, like currency or banknotes. The chips had no independent existence or value other than to facilitate gambling at Resorts [Casino].” While in a casino, “chips are merely symbols denominating the amount of the bets at stake,” the currency and goods in Second Life take on a fungibility of use that pushes the limitations that chips in a confined setting cannot. Not surprisingly, the users of other virtual worlds and other virtual currencies are already testing their supposed boundaries with great success. These parallel innovations inform the potential boundaries of Second Life. Despite clear rules and multiple attempts to eliminate real-money trading of goods from various virtual worlds, third-party grey markets are still used and easily accessible by users. Whereas, Blizzard, the owner World of Warcraft, has tried with minimal success to restrain the continued commodification of its virtual goods by banning real money transactions associated with the game, Sony, the owner of EverQuest, has taken the opposite approach by “creating its own auction site where it can control and profit from the player demand for sales of virtual items.”

Removing these issues from the virtual-world context does not solve the problem, as seen in markets of related technology. Chinese regulators have ordered websites to limit the use of “QQ coins,” a form of virtual money, stemming from “concerns that the online credits might be used for money laundering or illicit trade” after news reports that customers were using credits to “gamble, pay for phone-sex services and to shop online.” In keeping with its mission to create a user-defined world of general use in which people can interact, play, do business, and otherwise communicate, Linden takes an even more hands off approach then Blizzard, Sony, or the Chinese government, and unlike the Resorts casino in Zarin plays little no part in defining how Linden’s are used—in or out of Second Life. Shielding Second Life income from taxation under an imputation theory is proper only to the extent that the Second Life economy can be enforceably bounded—a requirement that is at best tenuous. . . ." From The Taxation of Virtual Worlds: Understanding Theories of Taxation Through an Analysis of the Second Life Economy by Tim Miano.

Second Life Tax: U.S. Federal Tax Laws Applied To In-World Second Life Activities

Part III.A: Introduction to Two Theories of Taxation: Cash-out Taxation and In-world Taxation

The first question one must answer is whether the activities in Second Life fit into the current tax system. One can begin with the Code and interpretations of §61. Recall that in Comm’r v. Glenshaw Glass, the Supreme Court interpreted gross income to mean “any undeniable accessions to wealth, clearly realized, and over which the taxpayer [has] complete domination.” This properly implicates notions of basis. For the exchange of some piece of property, § 1001 provides that taxpayers should subtract their basis from the amount realized, where “amount realized” is the sum of the cash received plus the fair market value of any property received. That is, when there is a realization event, a taxpayer must pay tax only on the total value that exceeds the original input value. How one measures basis in Second Life is a fundamental question one must answer in order to arrive at the taxable amount of income resulting from Second Life wealth. To reach basis, however, one must first one must establish the proper measure of virtual income. One cannot measure net income in Second Life until one can measure gross income, and since such measurements partially turn on how one defines the property rights, one must examine the property rights in Second Life that gave rise to the income.

It is through this property rights issue that one can divide the taxation of Second Life into two sweeping extremes: (1) taxation upon cashing out (i.e., no in-world taxation) or (2) dynamic taxation as accessions to wealth occur (i.e., some in-world taxation). One end of the spectrum dismisses the benefits derived and would not tax any of the economic activity that takes place in Second Life. That is, the only taxable events that would relate to Second Life are those that ex post involve accessions to wealth that are already taxed, such as receiving U.S. Dollars or receiving out-world services with a fair market value. The other end of the spectrum looks through the novelty at the underlying economic reality and tracks the theoretical framework developed above such that one’s taxes accrue in real-time on all gains that have a fair market value.

Although a detailed analysis of property rights is outside the scope of this paper, recognize that in the context of a cash-out method the legal property rights assigned to anything in Second Life makes no difference, but that in the context of in-world taxation, property rights can make an enormous difference. One can analyze these two methods in turn. First, notice that irrespective of how one defines the property rights or the property exchanged in Second Life, anytime that someone receives U.S. Dollars, either by cashing out their Linden Dollars or by making a trade of in-world goods for out-world benefits, a taxable event has occurred. If a resident has property rights to the goods in question, then upon trading, the individual has realized an economic gain possessing a clear fair market value with a floor equal to the selling price. If the individual lacks property rights to the “good” in question, then payment received is simply payment for the service of transferring access to use the underlying computer software in question. “If the non-tax law concludes that a virtual item is ‘property,’ then its sale is subject to the formula in § 1001.” If the non-tax law concludes that a virtual item is not property, then the transfers of the computer code are still “services paid for in exchange for other services.” But under either formulation, “the transaction produces gross income within the meaning of § 61.” Thus, even without wading through theories of property rights for virtual goods, one can still bound some part of Second Life activity that is subject to a gross income valuation.

If users of Second Life were to be taxed on in-world aspects of Second Life before they cashed-out, there would need to be defined property rights. By analogy, if an individual takes ownership of 100 Euros in payment for some service, that person is taxed on the fair market value of the money at the exchange rate for U.S. Dollars. This holds true even if the money remains in a European bank account and is never actually converted into U.S. or European paper money because there is a recognized property interest in this money and U.S. tax payers are taxed on world wide income. If Linden Dollars operate like Euros, then having 100 Linden Dollars in one’s Second Life account should properly be subject to taxation because there is a floating exchange rate and discernable value in terms of U.S. Dollars. However, in Second Life, Linden places contractual restrictions on Linden Dollars. The Second Life Terms Of Services (“TOS”) agreement provides that users have permission to use the “‘textures’ and/or ‘environment content’ that are both (a) created or owned by Linden Lab and (b) displayed by Linden Lab in-world,” yet it also states that “Second Life does not grant participants intellectual property rights to the items it provides in the virtual environment, such as land and Linden Dollars.” With respect to creations, Second Life’s TOS “expressly states that participants have intellectual property rights in their creations, to the extent provided by law.” “The TOS thus appears implicitly to grant land holders only a limited license to use land in Second Life” creating “multiple tiers of property, one tier in which participants have substantial ownership rights, and additional tiers in which participants are mere licensees of property created by Linden Lab.”

Having established that property rights can divide the taxation of Second Life activities into a cash-out method and in-world method, one can further bound the methods of taxation by examining the operational limitations that exist in the current tax law. Again, recall that in Comm’r v. Glenshaw Glass, the Supreme Court interpreted “income” to mean “any undeniable accessions to wealth, clearly realized, and over which the taxpayer [has] complete domination.” Notice that while this appears to unify the economic and statutory formulations of income, this definition explicitly imports realization as an operational limitation. In fact, the current tax doctrine actually creates three exceptions to gross income which significantly impact the analysis of virtual wealth. These operational restrictions are realization, valuation, and imputation. If either the cashing out method or some in-world taxation method is applicable to Second Life based on property rights alone, then one must examine these additional limitations in turn, to determine whether Second Life activities are otherwise precluded from taxation. As a secondary matter, one can use these operational limitations to explore more deeply the novel property rights issues that Second Life creates. From The Taxation of Virtual Worlds: Understanding Theories of Taxation Through an Analysis of the Second Life Economy by Tim Miano.

What Does It Mean that Virtual Worlds Have Economies?

B. What Are Virtual Worlds and What Does It Mean that Virtual Worlds Have Economies?

One of the most important and interesting aspects of virtual worlds such as Second Life is the depth and sophistication of the economies that develop among the users. Perhaps surprisingly, the economies of these virtual worlds frequently satisfy all the fundamental characteristics that neoclassical economic theory demands in the real world. First, the virtual items possessed by users—essentially the actualization of computer software—are no different than any other real-world goods. Users are human beings with real-world and virtual-world needs, and the properties of some of these items satisfy some of those needs. As in the real world, users are aware of the causal relationship between attaining the virtual good and satisfying a need, and users have ways of accessing these goods and retaining control over them. Most importantly, virtual goods are scarce, making them “economic goods” no different than real-world economic goods. This last point is especially true in Second Life, where, unlike other virtual worlds, all the virtual goods are created by the users themselves. “Well over 99% of the objects in Second Life are user created.”

But these virtual items are not merely economic goods. They are economic goods within an interactive environment that satisfies principles of exchange. Different users own different virtual goods and have unique subjective needs, which allow them to reverse value one other’s goods. As users recognize that others have these disparate needs and perceive that if they could trade they would receive a net benefit, the only additional element necessary for exchange is a mechanism for excluding others from using the good without permission. Like the real world, virtual worlds solve this problem by maintaining a system of property rights over virtual goods. Whether users create new goods, receive free goods, or trade others for goods, users hold virtual-world property rights for each of these virtual possessions—a right defined by the ability to exclude and to transfer that ability to another user. Thus, all of the necessary elements for bargained-for positive sum exchange of economic goods exist within Second Life.

These two characteristics, virtual economic goods and virtual environments that foster exchange, are not surprising. Indeed, the economic properties of these virtual goods are equally present in a computerized version of the board game Monopoly. Most people would agree that Monopoly money, helpful as it may to buy Park Place or pay the Luxury Tax, has no value outside of the well defined parameters of its game environment. However, several unique features—now norms within virtual worlds like Second Life—have distorted traditional demarcations of value, wealth, and trade. As noted, users have the ability to barter with each other for virtual items and trade these items among themselves. Users can sell items to each other using this currency in place of bartering. Unlike Monopoly, however, real-world systems of trade such as eBay and PayPal allow virtual-world users to auction/sell the rights to virtual goods or the right to an account that holds virtual goods for real-world currency. These items are subsequently transferred within the virtual world. Additionally, just like Monopoly, most virtual worlds like Second Life have their own form of currency. But perhaps most surprisingly, either through the companies themselves or through sophisticated virtual-world entrepreneurs, some virtual worlds including Second Life have currency exchanges where users can trade real-world currencies for virtual-world currency and vice versa. This means that all currency, goods, and services within the virtual marketplace have a corresponding real-world monetary value.

The implication of this real-world valuation of virtual-world goods is that users can participate in the virtual world for the purpose of creating real-world wealth. As such, there are implicit incentives within this system for users to participate in the activities that are wealth maximizing. Therefore, unlike Monopoly or other virtual-world games that may nevertheless have internal economies, virtual worlds such as Second Life take on the unique and dynamic ability to satisfy a whole range of real-world needs in ways that have never been done—needs that are measured in U.S. Dollars. From The Taxation of Virtual Worlds: Understanding Theories of Taxation Through an Analysis of the Second Life Economy by Tim Miano.

Theories of Taxation Through an Analysis of the Second Life Economy (Part I Introduction & I.A)

PART I: Introduction to Virtual Worlds & Second Life

In order to study the novel legal ramifications of Second Life, one must have a basic understanding of its parameters and nomenclature. Second Life is an Internet-based virtual world first developed by Linden Lab in 2003. Users within Second Life, known as residents, interact within the computer simulated environment via avatars. Avatars are customizable three-dimensional graphical representations of humanoids. More clearly then, the Second Life software acts as a gateway and provides a three-dimensional forum that enables users to interact with each other through motional avatars. This platform creates a sophisticated level of a social network interactivity combined with general aspects of the Metaverse, or the meta-universe, that exists through the instantiation of an Internet-based virtual reality. The stated goal of Linden Lab is to create a world like the Metaverse: a user-defined world of general use in which people can interact, play, do business, and otherwise communicate.

A. An Overview of the Development and Content in Second Life

Second Life is frequently clustered with massively multiplayer online games, such as World of Warcraft or EverQuest, because the software provides a graphical interface and permits user interactivity that appear quite similar to these games. However, Second Life is not a game as it lacks scores, winners/losers, levels, a defined objective, or other such traditional parameters that characterize an activity as a game. Instead, at its inception, the world within Second Life was analogous to an undeveloped tract of land offering little more than open space, which has since been developed with whatever residents want for themselves or for which there is a market. Second Life residents visit this virtual world almost as if it were a real place, exploring what others have created, meeting other residents, socializing, participating in individual and group activities, and buying items (virtual property) and services from one another. Thus, while Second Life is not exclusively a social networking site like MySpace, a user driven commercial forum like eBay, a currency exchange like Citibank, a game like EverQuest, or a encyclopedia like Wikipedia, Second Life contains aspects of all of these things. Given the success of these services to satisfy certain human needs and the ability of residents to create real-world wealth by satisfying the needs of residents, it is not surprising that modified facets of these services make their way into Second Life.

This point draws out one of defining characteristics of Second Life. Namely, besides the open land and the basic parameters/limitations/rules of the environment, all of the content is user generated. (“Well over 99% of the objects in Second Life are user created.”) Using open access software, Second Life computer protocol, and three-dimensional modeling tools, any resident can build virtual buildings, landscape, vehicles, furniture, machines, games, people, and generally anything (referred to here as “items”) to use or to sell. Residents can incorporate various graphics, animation, and sound tools to create elaborate, farcical, or realistic content. It is this method of generating content that has given rise to the elaborate system of internal (as opposed to legally enforceable) property rights found in Second Life—one of the necessary conditions for a viable system of exchange. The legal status of the property right is unclear and will be examined in the context of taxation in greater detail in Part III below.

As an introductory matter, under Linden Lab’s Terms of Service agreement, any resident who creates an item retains copyrights in that item. Thus, from the perspective of the virtual-world resident the item is like personal property, but from the perspective of the real-world user the item is like duplicable software and more analogous to intellectual property. For a particular item then, users have some flexibility in how they may exercise their property rights. For example, the user who creates an item can limit it to behave like personal property by labeling it as a “no copy.” This means that a subsequent owner cannot reproduce, but may use, the underlying computer code, raising issues of use rights verses ownership rights. “No mod” on the other hand means that the owner may not modify the item’s characteristics, much like closed source software which is supposed to prevent hacking and customization—creating a more complex hierarchy of use rights. Finally, an owner of an item can label it “no trans,” which disallows transfer of ownership to another resident. Most importantly, all of these limitations can spring upon transfer. That is, creators or current owners can set these rights for future owners, much like land use covenants or servitudes. From a legal perspective then, any piece of property within Second Life can possess a wide array of property rights borrowing from real, personal, and intellectual property that remains, more or less, user-defined.

Theories of Taxation Through an Analysis of the Second Life Economy (Introduction)

Introduction:

A virtual world is a computer simulated environment in which human users interact with each other via graphical representations of themselves. Second Life is an Internet-based virtual world developed and released by Linden Lab in 2003. Other popular examples of virtual worlds include massively multiplayer online games such as World of Warcraft, which boasts more than 8 million users, and EverQuest, which as early as 2002 was estimated to have the 77th largest GDP in the world (between Bulgaria and Russia). Typically, virtual worlds appear similar to the real world, with constraints such as gravity, topography, locomotion, and communication.

One of the most important and interesting aspects of virtual worlds such as Second Life is the depth and sophistication of the economies that develop among the users. In fact, some virtual worlds, including Second Life, have currency exchanges where users can trade real-world currencies for virtual-world currency and vice versa. This means that the currency, goods, and services within the virtual-world marketplace have a corresponding real-world monetary value. The implication of this real-world valuation of virtual-world goods is that users can participate in the virtual-world activities for the purpose of creating real-world wealth. As such, there are implicit incentives within this system for users to participate in the activities that are wealth maximizing.

The overarching purpose of this work is explore the federal income tax consequences of the creation of Second Life—a virtual world where real people can engage in behavior constrained only by the time and effort of the users who wish to have a medium for a particular activity. Because it has developed the most mature systems of property rights, trade, and fungibility of wealth, and because it has been designed intentionally to be a more-or-less unregulated three-dimensional free market, Second Life is the focus of this work. Note, however, that much of the discussion also applies to the many other virtual worlds on the Internet, some of which currently boast millions more users and much larger internal economies than Second Life.

This work will proceed in three major parts. Part I will introduce the basic terminology and boundaries of Second Life and virtual worlds in general. It argues that the goods and services in Second Life posses all of the same economic characteristic as real-world goods and services, and that it is improper to dismiss Second Life as no different than the video games that have, in part, given rise to the technology that makes Second Life possible. Part II will introduce some basic concepts for income taxation and briefly examine the Haig-Simons definition of income. It will examine Haig’s original work that gave rise to this definition, and then, using introductory economic concepts develop the fundamental framework underlying the modern definition of income that Haig and Simons failed to explain. The purpose of this inquiry is to establish that as a purely theoretical matter, the wealth generated from the activities in Second Life is indistinguishable from those in the real world. Finally, having established that Second Life wealth is taxable income under the theoretical premises for § 61, Part III will analyze the activities in Second Life under the current tax law. First it will examine whether the three primary operational limitations that currently exists in the tax code would exempt Second Life from taxation. Second, using partnership tax law as a model, it will explore whether the efficiencies and substantial reduction in transaction costs that are unique Second Life too easily create accidental tax liability such that the current tax law fails to incorporate operational limitations special to Second Life. This work concludes that under the current law the users of Second Life would properly be subject to some form of taxation for their in-world activities. It also briefly speculates at some policy reasons for why the government should delay taxing those activities despite the applicability of the tax law and lists some important tax questions left unanswered by this work. From The Taxation of Virtual Worlds: Understanding Theories of Taxation Through an Analysis of the Second Life Economy by Tim Miano.