All transfers of base Bitcoins (with the sender's and receiver's digital addresses) are published in the public record - specifically in Bitcoin's distributed database. So in that sense, the flow of money between Bitcoin accounts is not untraceable at all. However, users of Bitcoin can, if they wish, take measures to make it more difficult to trace their flow of transactions.
First, at the most basic level, a user can create a new receiving address for each payment they receive, which makes it more difficult to identify the recipient. Still, if the coins received are later spent together with other coins in the same wallet, this ties them together and makes it easier to identify a pattern of payments going to a single recipient. The real-world identity of that recipient might then potentially be traced by using conventional investigation methods (through contacts or computers used to distribute addresses, etc.).
Another layer of difficulty can be added by using a third-party service such as a Bitcoin "laundromat" which accepts Bitcoins from many sources, mixes them together in a single wallet and then redistributes them from random addresses to intended recipients. Such a service can make it very difficult if not impossible to show that a transaction took place between a given buyer and a given seller.
On the flip side, if a Bitcoin user wishes to prove that he/she ordered a given transfer, that can be easily accomplished by digitally signing a statement of one's identity using the private key associated with the sender's address.
Most casual users of Bitcoin will probably not resort to taking extra measures to either hide or reveal their identities, at least not until tools exist that make it easy and convenient for them to do so.
Still, in time, such tools should become more readily available as the Bitcoin economy continues to develop, and a sufficiently motivated user can find or develop such tools even now, so this raises the question: How are governments going to enforce income taxes on income that is in the form of Bitcoins?
Some crypto-anarchists might say, "They can't; that's the whole point, let the governments fall!"
But I, for one, am in favor of (sufficiently good) government, and I don't expect governments would fall anyway (since they can always just tax in other ways), so I would like to propose a different, and (IMHO) much saner answer, something that I think we need to do anyway, namely:
We should abandon the income tax, and replace it with an excise tax on the development (extraction or first processing) of raw natrual resources: fossil fuels, minerals, arable land, forests, fisheries. Such a tax is enforceable because the government can go after and inspect the (generally large-scale) physical facilities where such processing is done: oil fields, refineries, mines, new farms, newly cleared forest, large fishing vessels. Cryptocurrency can't hide such activities.
Such a tax would naturally be passed down along supply chains, and so would impact end users (consumers or companies) in proportion to the extent to which they cause consumption of raw resources, whether directly or indirectly, through the products and services that they buy.
As a result, this form of taxation would provide a very strong incentive for companies and individuals to minimize their personal level of consumption, and give them an easy price signal to help them do so, since in this system the cheapest products would be those that are produced most efficiently in terms of raw resources consumed. So by simply being a frugal shopper, one would automatically also be helping conservation efforts.
Furthermore, by tuning the tax rates on individual types of resources to match their projected ecological impact on long-term public health and safety, this new tax regime would foster the public interest, and would do wonders to make our civilization more sustainable, and help to ensure a much longer and more glorious future for humanity on this planet.
One final note: This consumption tax would not imply a tax increase, just a shift in the tax burden from less-wasteful to more-wasteful activities. An individual would not necessarily be paying any more in taxes than before - probably less, to the extent that he is able to adapt to a low-environmental-impact lifestyle. To make the transition easier, the consumption tax could be phased in (and the income tax phased out) over a number of years.
This is something we need to do anyway, to save the Earth from excessive development and spare ourselves from a severe resource crisis and ecological reckoning down the road. The difficulty of taxing Bitcoin income just makes the case for getting rid of the income tax even better. So this is yet another reason why everyone should adopt Bitcoin - to give governments an additional impetus to restructure their tax base in this way that will best serve the public interest.
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