It's worth looking at fiat and cash and if this money is 'tainted'. You're right that all money (no matter which form of money: cash, fiat, crypto, whatever) is going to be used for some sort of activity that in some countries violates some law. This doesn't make it any worse than before this activity, so it continues to be used just the same.
For example:
Most banknotes have traces of cocaine on them; this has been confirmed by studies done in several countries. In 1994, the U.S. 9th Circuit Court of Appeals determined that in Los Angeles, out of every four banknotes, on average more than three are tainted by cocaine or another illicit drug.
Poop. A 2002 report in the Southern Medical Journal reported that paper money can carry more germs than a household toilet. A whopping 94% of dollar bills tested contained harmful pathogens like staphylococcus - the bacteria that causes staph infections, and can be passed by not washing your hands after using the restroom, or from contaminated food and dairy products.
So as you alluded to, basically
'if everything's tainted, nothing's tainted'.
What we can do?
Run our own nodes, hold our keys, accept any Bitcoin and refuse any random arbitrary party's definition of 'taint'. Otherwise an economy doesn't function. Nobody checks a dollar bill's serial number or the substances found on it. Everyone just accepts it and uses it, certain that it will be accepted.
If someone were to start differentiating which bills they accept, they would be cutting themselves out of part of the economy; we should treat those who try to have this attitude on Bitcoin, the same way. Stop making business with them if they don't want our coins, instead of trying to convince them our coins are good (by sending KYC documents or whatnot) - so they understand they're cutting themselves out of part of the economy, not the other way round.