Paradigm researchers Dan Robinson and Dave White introduced a new concept called the “MEV tax.” This mechanism enables applications to reclaim part of the MEV from transactions. The goal is to redistribute the value of MEV, preventing searchers who execute transactions from taking all the value. This system can be effectively implemented on OP Stack Layer 2 networks like OP Mainnet, Base, and Blast.

Introduction to MEV Tax

The MEV tax is a system that allows smart contracts to automatically collect fees by analyzing the priority fees in transactions. In this framework, smart contracts take a portion of the MEV tax based on the priority fees. Priority fees are paid by users to speed up their transaction confirmations on the network. Following the implementation of EIP-1559, Ethereum’s transaction fees are split into base fees and priority fees. The base fees are set automatically by the network and adjust dynamically according to network congestion, while priority fees are additional payments users make to block proposers to incentivize faster processing of their transactions.

Smart contracts review the priority fees in transactions and charge a proportional extra fee, known as the MEV tax. For instance, under the MEV tax mechanism, if a user pays 1 unit of priority fee to a block proposer to prioritize their transaction, a searcher who wants to capture all the MEV from this transaction (e.g., a profit of 100 units) must pay 99 units to the smart contract, following a 1:99 fee ratio set by the smart contract. This 99 units will be returned to the application (e.g., used to provide rewards to users). Without the MEV tax, if a user pays 1 unit of priority fee, the proposer receives 1 unit for processing the transaction, but the MEV (100 units) generated by this transaction will all go to the searcher.

Effectiveness Based on Competitive Priority Ordering Rules

The effectiveness of the MEV tax relies on the “competitive priority ordering” rules:

1. Sorting by Priority Fees: Block proposers should sort transactions by priority fees, prioritizing those with higher fees.
2. No Censorship: Block proposers cannot censor or exclude any transactions, even if they have lower priority fees.
3. No Peeking or Delays: Block proposers cannot look at transaction contents ahead of time or unjustifiably delay certain transactions.

These rules make the MEV tax effective only on OP Stack Layer 2 networks. This is because the block proposers (sequencers) on these chains adhere to competitive priority ordering. If sequencers break these rules, they can manipulate transaction order to avoid the MEV tax and capture the value themselves.

For Ethereum Layer 1, block construction happens through competitive block auction systems like MEV-Boost, where multiple block builders compete to maximize revenue by including high-fee transactions. Since the MEV tax reduces builders’ earnings, in a highly competitive block-building environment, builders will prefer transactions without the MEV tax, making this mechanism ineffective on Ethereum.

Problems Solved by the MEV Tax

The MEV tax can be implemented by any smart contract without requiring specific external tools, allowing developers to create custom fee models tailored to their applications. This flexibility ensures that various blockchain protocols and applications can optimize their strategies while maintaining compatibility with other systems. For example:

1. Optimizing DEX Transactions: In a DEX, introducing an MEV tax means that transaction execution prices depend not only on market supply and demand but also on the MEV tax. To secure better prices and complete transactions quickly, searchers must pay higher MEV taxes. These fees can enhance the transaction’s priority in the block or serve as a reward for users or liquidity providers, potentially changing the execution price and reducing price slippage.
2. Reducing Losses and Rebalancing Issues for AMM Liquidity Providers: AMMs can prioritize transactions with higher MEV taxes, recovering some profits from arbitrageurs and returning them to the AMM or liquidity providers. This ensures more stable returns for liquidity providers.
3. Capturing “Backrun” MEV from Transactions: By integrating the MEV tax into smart contract wallets, users’ wallets can automatically charge MEV tax during transactions. When other market participants try to exploit the MEV generated by a user’s transaction, they must pay the MEV tax. This tax can be returned to the user who made the original transaction, effectively allowing users to capture the MEV generated by their transactions, protecting their interests.

Limitations of the MEV Tax

Apart from its effectiveness being highly dependent on sequencers strictly following competitive priority ordering rules, the MEV tax faces several other limitations. For instance, when blocks are completely full, block proposers might need to drop lower-priority transactions rather than just placing them later in the block. Moreover, the success of the MEV tax requires market competition, meaning that trading opportunities need to be widely recognized. For applications based on user intent, this might necessitate revealing users’ intentions, which could lead to potential value leakage in a competitive environment.

While the MEV tax mechanism faces certain challenges and limitations, it represents an innovative way to redistribute MEV more fairly, redirecting MEV profits, which would otherwise go entirely to searchers, back to the applications. The MEV tax and MEV Share share a similar goal of finding ways to return MEV to promote fair distribution within the MEV ecosystem.

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