Did I discover an easy way to make money via PayPal and cashback credit card? If so, is it legal and is the money taxable?

Congrats! You found a legitimate arbitrage situation that indeed could make you some money. These are increasingly rare, which does make it kind of cool, even if you end up not taking advantage of it. IMHO it's not worth it due to the spending cap.

The deal you Discovered appears to pay 5% on PayPal transactions, including those made to friends and family, but unfortunately it is capped at $1500. So, the maximum cash back you can achieve is $75. The minimum the PayPal fees would be is 2.9% + $0.30 for a single transaction, which is $43.80. Your profit from this would be $31.20 minus whatever you have to give to your friend to convince them to go along with it and give you your money back.

In the US, cash back on purchases from individuals (but not businesses) is typically treated as a discount on your purchase, and is not taxable.

Here's the fine print of the deal:

Many years ago some US bank gave you air miles for cash withdrawals, and a couple took out all their savings in cash, paid it back in, drew it all out again and repeat. They managed to withdraw about 7 million dollars, obviously also paid in 7 million, getting tons of air miles, until the bank acted.

That was apparently totally legal.

I am not a lawyer but I suspect that if the finance/legal bods at your credit card company and/or paypal realized this was going on they would consider it to be a form of cash advance.

Paypal explicitly prohibits the use of PayPal accounts as a means of obtaining cash advances. IIRC Credit card companies often also reserve the right to treat a transaction that is effectively a cash advance as one, even if it was reported through the payment network as a purchase.

In connection with your use of our websites, your PayPal account, the PayPal services, > or in the course of your interactions with PayPal, other PayPal customers, or third parties, you must not:
<--snip other prohibitions-->
Provide yourself a cash advance from your credit card (or help others to do so);

Yes, and it falls into the same category as banks paying you money to open a checking account with them.

Businesses call this "customer acquisition costs" and they work pretty hard to enumerate it to a specific number. They can tell you it costs them on average $231.14 in marketing costs to land a new customer (or whatever the figure is for them).

Sometimes this can be direct; banks used to give out toasters for opening a new account. PBS gives out tote bags.

So some bright bulb in the marketing department said "hey, why don't we just pay this money to our customers directly?" Because people would rather have money than a toaster. You've seen 1000 variations on this... This promotion of PayPal's is cut from that cloth.

As TTT points out, PayPal has installed practical limits to the promotion, which make it "not worth the trouble" to do it in the manner you plan. However it works out rather nicely to use the promotion the way PayPal intends: to just buy stuff you're gonna buy anyway, but instead, use PayPal to pay for it.

That is precisely the goal: to acclimate you into the idea of using PayPal in ways you've never used before. The idea is, you'll find it so convenient you'll keep doing it once the promotion runs out.