Title: Introducing a New Concept: MEV Tax
Researchers Dan Robinson and Dave White from Paradigm have introduced a revolutionary concept known as the “MEV tax.” This mechanism allows applications to reclaim a portion of MEV from transactions, aiming to redistribute the value of MEV and prevent it from being solely captured by transaction frontrunners. This mechanism can be effectively implemented on protocols such as OP Mainnet, Base, and Blast within the OP Stack L2 ecosystem.
Introduction to MEV Tax
MEV taxes enable smart contracts to automatically extract fees by analyzing the priority fee in transactions. Under this framework, smart contracts levy a certain percentage of MEV tax based on the priority fee of the transaction. The priority fee is the fee users pay to expedite the confirmation of their transactions on the network. Following EIP-1559, Ethereum’s 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 miners to prioritize their transactions.
Smart contracts charge a proportionate additional fee based on the priority fee of the transaction, known as the MEV tax. For example, under the MEV tax system, a user pays a priority fee of 1u to the miner to incentivize them to prioritize the transaction. To ensure that all MEV from the transaction is captured by the user (e.g. earning 100u in profit), the frontrunner must pay 99u to the smart contract based on the 1:99 fee ratio set by the interacting smart contract. This 99u is then returned to the application (for user rewards, etc.). Without MEV tax, the user would pay a priority fee of 1u, and the miner would receive 1u for processing the transaction, while all MEV generated (100u) would go to the frontrunner.
Effectiveness Based on Competitive Priority Ordering Rules
The effectiveness of MEV tax relies on the rules of “competitive priority ordering”:
Sort by priority fee: Miners should prioritize transactions based on the highest priority fee, ensuring that transactions with higher fees are processed first.
No censorship: Miners cannot censor or exclude any transactions, even those with lower priority fees.
No front-running or delays: Miners cannot front-run transactions or delay their processing without reason.
MEV tax is only effective on OP Stack L2 chains where miners (sorters) adhere to competitive priority ordering rules. Violating these principles allows miners to manipulate transaction order to evade MEV tax and capture the value for themselves.
For Ethereum L1, block construction occurs through competitive block-building auctions like MEV-Boost, where multiple block producers compete to maximize income, including high-fee transactions. Due to the reduction in income caused by MEV tax, block producers in highly competitive environments may prioritize transactions without MEV tax, rendering this mechanism ineffective on Ethereum.
Issues Addressed by MEV Tax
MEV tax can be adopted by any smart contract without specific external infrastructure, allowing developers to customize fee models based on their application needs. This flexibility ensures that different blockchain protocols and applications can optimize strategies while remaining compatible with other systems. For example:
Optimizing DEX transactions: Introducing MEV tax in DEX transactions means that transaction execution prices not only depend on market supply and demand but also include a component of MEV tax. Frontrunners must pay higher MEV taxes to expedite transactions and potentially receive better prices. These fees can be used to increase the transaction’s priority in the block or as a reward mechanism for users or liquidity providers, potentially reducing transaction price slippage indirectly.
Reducing losses and rebalancing issues for liquidity providers in AMMs: AMMs can prioritize transactions with higher MEV taxes, allowing them to recoup profits from arbitrageurs and redistribute them to AMMs or liquidity providers, ensuring more stable income for liquidity providers.
Capturing “backrun” MEV from transactions: By integrating MEV tax into smart contract wallets, users’ wallets can automatically collect MEV tax during transactions. This requires other market participants attempting to exploit MEV from user transactions to pay MEV tax, which can then be returned to the original user. This mechanism effectively allows users to capture the MEV generated by their transactions, protecting their interests.
Limitations of MEV Tax
In addition to the strict adherence of sorters to competitive priority ordering rules, MEV tax faces other limitations. For instance, when blocks are fully filled, miners may have to prioritize higher priority transactions over lower ones rather than including them later in the block. The success of MEV tax relies on market competition, meaning that transaction opportunities need to be widely known, potentially requiring the disclosure of user intentions for some intent-based applications, leading to potential value leakage in competition.
Despite facing challenges and limitations, the innovative approach of MEV tax offers a way to redistribute MEV more fairly, returning MEV profits that would have otherwise gone to frontrunners back to applications. MEV tax, similar to MEV Share, aims to find ways to return MEV and promote fair distribution within the MEV ecosystem.
