What is the MEV tax and who pays it?

Author: 0XNATALIE, Source: Author's Blog

Paradigm researchers Dan Robinson and Dave White proposed a new concept "MEV tax". The MEV tax mechanism allows applications to recover part of the MEV from transactions, with the goal of redistributing the value of MEV and preventing all of this value from being owned by the searchers who execute the transaction. This mechanism can be effectively implemented on OP Stack L2 such as OP Mainnet, Base and Blast.

Introduction to MEV Tax

MEV taxes are a mechanism that allows smart contracts to automatically extract fees by analyzing the priority fee in transactions. Under this framework, smart contracts charge a certain percentage of MEV taxes based on the priority fee of the transaction. The priority fee is the fee paid by users to speed up the confirmation of their transactions by the network. After EIP-1559, Ethereum's transaction fees are divided into base fees and priority fees. The base fee is set automatically by the network and dynamically adjusted based on network congestion, while the priority fee is an additional fee that users pay to block proposers to incentivize their transactions to be processed first.

Smart contracts check the priority fee of a transaction and charge a proportional additional fee accordingly, called the MEV tax. For example, under the MEV tax, users pay a priority fee of 1u to block proposers to incentivize them to process this transaction first. In order for the searcher to get all the MEV from this transaction (for example, to make a profit of 100u), they must pay 99u to the smart contract according to the 1:99 ratio fee set by the smart contract that interacts with this transaction, and these 99u will be returned to the application (for providing rewards to users, etc.). In the absence of the MEV tax, users pay a priority fee of 1u, and the proposer will also get 1u if they process this transaction, but the MEV (100u) generated by this transaction will go to the searcher.

Effectiveness based on competitive priority ordering

The effectiveness of the MEV tax is based on the rule of "competitive priority ordering":

1. Sort by priority fee: Block proposers should sort transactions according to their priority fees, and transactions with high priority fees should be processed first.

2. No censorship: Block proposers cannot censor or exclude any transaction, even transactions that pay lower priority fees.

3. No peeking and delay: Block proposers cannot peek at transaction contents in advance, nor can they delay the processing of certain transactions without reason.

Based on this rule, MEV tax is only effective on OP Stack L2. Because block proposers (sorters) on these chains follow the rules of competitive priority sorting. If sorters violate these principles, they can also evade MEV tax by manipulating the order of transactions and capture value for themselves.

For Ethereum L1, blocks are built through competitive block auction systems such as MEV-Boost, where multiple block builders compete to maximize revenue by including high-fee transactions. Since the MEV tax reduces the builder's revenue, in a highly competitive block environment, builders will tend to prioritize transactions that do not implement the MEV tax, so this mechanism is invalid on Ethereum.

Problems solved by the MEV tax

The MEV tax can be adopted by any smart contract without the need for specific external facilities, allowing smart contract developers to customize the charging model according to their application needs. This flexibility ensures that different blockchain protocols and applications can be optimized according to their own strategies while maintaining compatibility with other systems. For example:

• Optimizing DEX transactions:When the MEV tax is introduced in DEX, the execution price of the transaction is not only determined by the market supply and demand, but also includes the MEV tax component. Because in order to complete the transaction first and get a better price, the searcher needs to pay a higher MEV tax. This part of the fee can be used to increase the priority of the transaction in the block, or as a reward mechanism, fed back to the user or liquidity provider, which may change the execution price of the transaction and indirectly reduce the slippage of the transaction price.

• Reduce the loss and rebalancing problem of liquidity providers in AMM:AMM can be set to prioritize transactions that pay higher MEV taxes, so that a part of the profit can be directly recovered from arbitrageurs and returned to AMM or liquidity providers, ensuring that the income of liquidity providers is more stable.

• Capture the "backrun" MEV generated by transactions:By integrating the MEV tax into the smart contract wallet, a mechanism is designed to allow the user's wallet to automatically collect the MEV tax when trading. In this way, when other market participants try to take advantage of the MEV generated by the user's transaction, they must pay the MEV tax, which can be returned to the user of the original transaction. This mechanism effectively allows users to capture the MEV generated by their own transactions and protect their interests.

Limitations of MEV Tax

In addition to the effectiveness mentioned above, which is highly dependent on the sorter's strict adherence to the competition priority sorting rules, the MEV tax also faces some other limitations. For example, when a block is completely filled, the block proposer may have to abandon lower priority transactions instead of simply including them in the later stages of the block. In addition, the success of the MEV tax requires competition in the market, which means that the opportunity for transactions needs to be widely known. For some applications based on user intent, this may require the user's intent to be made public, resulting in potential value leakage in the competition.

Although the MEV tax mechanism faces some challenges and limitations, this innovative approach is also a way to redistribute MEV reasonably, returning the MEV profits that originally belonged to the searchers to the applications. The purpose of MEV tax and MEV Share is similar, both of which are looking for ways to return MEV to promote fair distribution of the MEV ecosystem.