What is MEV tax? Who pays the tax?
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What is MEV tax? Who pays the tax?
MEV tax redistributes MEV by returning profits that were originally captured entirely by searchers back to the application.
Navigating Web3 tides with focused insightsAuthor: 0XNATALIE
Paradigm researchers Dan Robinson and Dave White have introduced a new concept called the "MEV tax." The MEV tax mechanism allows applications to reclaim part of the MEV from transactions, aiming to redistribute MEV value that would otherwise be entirely captured by searchers executing those transactions. This mechanism can be effectively implemented on OP Stack L2s such as OP Mainnet, Base, and Blast.
Introduction to MEV Tax
An MEV tax is a mechanism that enables smart contracts to automatically extract fees by analyzing the priority fee within a transaction. Under this framework, a smart contract charges a proportional MEV tax based on the transaction’s priority fee. A priority fee is the amount users pay to increase the likelihood of their transaction being confirmed quickly by the network. After EIP-1559, Ethereum transaction fees are split into a base fee and a priority fee. The base fee is set automatically by the network and dynamically adjusted according to congestion levels, while the priority fee is an additional payment made by users to block proposers as an incentive for prioritizing their transaction.
Smart contracts inspect the priority fee of a transaction and charge a proportional additional fee—known as the MEV tax. For example, under an MEV tax scheme, a user pays 1u in priority fees to incentivize block proposers to prioritize their transaction. If a searcher wants to capture all the MEV from this transaction (e.g., yielding a profit of 100u), they must pay 99u to the smart contract according to a predefined 1:99 ratio, leaving only 1u for themselves. The 99u collected goes back to the application (to fund user rewards, etc.). Without an MEV tax, the user still pays 1u in priority fees, which the proposer receives upon including the transaction—but in this case, the full 100u of MEV generated would go entirely to the searcher.
Effectiveness Based on Competitive Priority Ordering Rules
The effectiveness of the MEV tax relies on the principle of "competitive priority ordering":
Priority-based sorting: Block proposers should order transactions based on the level of priority fees, with higher-priority-fee transactions processed first.
No censorship: Block proposers must not censor or exclude any transaction, even those paying lower priority fees.
No peeking or delaying: Block proposers cannot preview transaction contents in advance nor unjustifiably delay processing certain transactions.
This mechanism works only on OP Stack L2s because the sequencers (block proposers) on these chains follow competitive priority ordering rules. If a sequencer violates these principles, it could manipulate transaction ordering to evade the MEV tax and capture the value for itself.
In contrast, on Ethereum L1, block construction occurs via competitive block-building auctions like MEV-Boost, where multiple builders compete to maximize revenue by including high-fee transactions. Since MEV taxes reduce builder profits, in such a highly competitive environment, builders will tend to favor transactions that do not implement MEV taxes, rendering the mechanism ineffective on Ethereum.
Problems Solved by MEV Tax
Any smart contract can adopt the MEV tax without requiring special external infrastructure, allowing developers to customize fee models according to their application needs. This flexibility enables different blockchain protocols and apps to optimize according to their own strategies while maintaining compatibility with other systems. For example:
Optimizing DEX trades: When introducing MEV taxes into DEXes, execution prices depend not only on supply and demand but also incorporate the MEV tax component. To front-run a trade and secure a better price, searchers must pay a higher MEV tax. This extra fee can be used to boost the transaction’s priority in the block or serve as a reward distributed back to users or liquidity providers, potentially improving execution prices and indirectly reducing slippage.
Reducing losses and rebalancing issues for AMM liquidity providers: AMMs can prioritize transactions that pay higher MEV taxes, directly reclaiming part of the profits from arbitrageurs and returning them to the AMM or its liquidity providers, thereby stabilizing LP returns.
Capturing “backrun” MEV generated by transactions: By integrating MEV taxes into smart contract wallets, mechanisms can be designed so that users’ wallets automatically collect MEV taxes during transactions. When other market participants attempt to exploit MEV arising from a user’s transaction, they must pay the MEV tax, which can then be returned to the original transacting user. This effectively enables users to capture MEV generated by their own activity, protecting their interests.
Limitations of MEV Tax
Beyond its reliance on sequencers strictly adhering to competitive priority ordering, the MEV tax faces several other limitations. For instance, when blocks are fully packed, block proposers may have no choice but to drop lower-priority transactions rather than simply placing them later in the block. Additionally, the success of MEV taxes requires market competition, meaning trading opportunities must be widely known. For intent-based applications, this might require publicly revealing user intents, potentially leading to value leakage in competitive environments.
Despite these challenges and limitations, the MEV tax represents an innovative approach to fairly redistributing MEV—returning profits that would otherwise go entirely to searchers back to applications. Similar in goal to MEV Share, the MEV tax seeks methods to return MEV value and promote fairer distribution across the MEV ecosystem.
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