Title: Introducing a New Concept: MEV Tax
Researchers at Paradigm, Dan Robinson and Dave White, have introduced a groundbreaking concept known as the “MEV tax”. This mechanism allows applications to reclaim a portion of MEV from transactions in order to redistribute the value of MEV and prevent it from being entirely captured by transaction frontrunners. This mechanism can be effectively implemented on OP Stack L2 networks such as OP Mainnet, Base, and Blast.
Introduction to MEV Tax
MEV taxes are a mechanism that enables smart contracts to automatically extract fees by analyzing the priority fees in transactions. Within this framework, smart contracts charge a certain percentage of MEV tax based on the priority fees of transactions. Priority fees are the fees paid by users to expedite the confirmation of their transactions on the network. Following EIP-1559, Ethereum transaction fees are divided into base fees and priority fees. The base fee is set automatically by the network and adjusts dynamically based on network congestion, while the priority fee is an additional fee paid by users to incentivize block proposers to prioritize their transactions.
Smart contracts charge additional fees proportionate to the priority fees of transactions, known as MEV tax. For example, under MEV tax, a user pays 1u of priority fee to the block proposer to incentivize them to prioritize the transaction. In order for the frontrunner to capture all the MEV from this transaction (e.g. profiting by 100u), they must pay 99u to the smart contract based on the 1:99 fee ratio set by the interacting smart contract, with the 99u returned to the application (for rewarding users, etc.). Without MEV tax, if a user pays 1u in priority fees, the proposer would receive 1u, but all the MEV generated by the transaction (100u) would go to the frontrunner.
Effectiveness Based on Competitive Priority Ordering Rules
The effectiveness of MEV tax is based on the rules of “competitive priority ordering”:
Sorting by priority fees: Block proposers should prioritize transactions based on the highest priority fees, ensuring that transactions with higher priority fees are processed first.
No censorship: Block proposers cannot censor or exclude any transactions, even those with lower priority fees.
No peeking or delays: Block proposers cannot peek at transaction content in advance or needlessly delay the processing of certain transactions.
Based on these rules, MEV tax is only effective on OP Stack L2 networks where block proposers (sorters) adhere to competitive priority ordering rules. If sorters violate these principles, they can manipulate the order of transactions to evade MEV tax and capture the value for themselves.
For Ethereum L1, block construction occurs through competitive block-building auction systems like MEV-Boost, where multiple block builders compete to maximize revenue by including high-fee transactions. Since MEV tax reduces the earnings of builders, in highly competitive block-building environments, builders are likely to prioritize transactions not subject to MEV tax, rendering this mechanism ineffective on Ethereum.
Issues Addressed by MEV Tax
MEV tax can be adopted by any smart contract without the need for specific external infrastructure, allowing smart contract developers to customize fee models based on their application requirements. This flexibility ensures that different blockchain protocols and applications can optimize according to their strategies while remaining compatible with other systems. For example:
Optimizing DEX transactions: Introducing MEV tax in DEX means that transaction execution prices depend not only on market supply and demand but also include the component of MEV tax. Frontrunners need to pay higher MEV tax to expedite transactions and obtain better prices. This fee can be used to increase the transaction’s priority in the block or as a reward mechanism, returning to users or liquidity providers, potentially altering the execution price and indirectly reducing transaction price slippage.
Reducing losses for liquidity providers in AMMs and addressing rebalancing issues: AMMs can prioritize processing transactions that pay higher MEV taxes, directly recouping profits from arbitrageurs and returning them to the AMM or liquidity providers, ensuring more stable returns for liquidity providers.
Capturing “backrun” MEV generated by transactions: By integrating MEV tax into smart contract wallets, mechanisms can be designed to automatically collect MEV tax from user transactions. This way, when other market participants attempt to profit from MEV generated by user transactions, they must pay MEV tax, with this revenue returned to the original user. This mechanism effectively allows users to capture MEV generated by their transactions, protecting their interests.
Limitations of MEV Tax
In addition to the high dependence of MEV tax on sorters strictly adhering to competitive priority ordering rules, there are other limitations. For instance, when blocks are completely full, block proposers may have to prioritize higher-priority transactions instead of simply including lower-priority ones later in the block. Additionally, the success of MEV tax requires competition in the market, meaning that the opportunity for transactions needs to be widely known, which may require disclosing user intent for some intent-based applications, potentially leading to value leakage in competition.
While the MEV tax mechanism faces challenges and limitations, this innovative approach is a way to fairly redistribute MEV and return profits to applications instead of solely benefiting frontrunners. MEV tax and MEV Share serve similar purposes, both seeking ways to redistribute MEV to promote fair distribution in the MEV ecosystem.