When transaction volume gets to the point there is competition getting into a block, ppcoin has the same Bitcoin logic that above half megabyte region of the block only higher and higher fee paying transactions are included. This is again implicit protocol and default client behavior and not enforced.
I see. So the default behavior for clients will be that higher transaction fees increase priority. However, in contrast to bitcoin, the transaction fees do not get redistributed to the validation nodes, but get destroyed instead.
Yes I understand all your concerns. If it becomes a widespread problem down the road (although I highly doubt) then protocol will be revised to correct the problem.
Adjusting transaction fee would require a hard-fork yes. I am not as strict as Gavin on the issues of hard-fork. I believe even if you design a convoluted transaction fee model most likely hard fork would be necessary somewhere else anyway.
Honestly, I think the attempt to remove monetary incentives from the transaction schedule, if the blockchain gets crowded, is futile. I predict the following will happen: Validation nodes will "sell" their transaction volume in form of specially crafted transaction types to users. I would have to think for a while how that would be technically accomplished, but I am pretty certain people will find a way.
However, the above scenario also shows a way how the "situation" can be fixed without requiring a hard fork.
ADDENDUM: After thinking about it for a moment, I think a simple solution would be if validation nodes publish a BTC address, which they consider for transaction fee payments. Then they can advertise that they only include transactions which include an output to that particular address. This works perfectly, since NOT including transaction doesn't impose a penalty. Thus the pressure is on the user.
Spinning that scenario a little bit longer suggests an interesting constellation: Validation nodes with large mining power can advertise their transaction volume at high prices, because they can guarantee fast transaction processing, while validation nodes with small mining power have to settle for lower prices. This is a totally screwed up situation.
How does that differ from bitcoin? It doesn't, bitcoin is susceptible to the same dilemma. However, in bitcoin the bargaining power is with the user creating the transaction, while in ppcoin the bargaining power is with the validation node, for two reasons: 1) POW blocks and POS blocks always provide a reward, irrespective of the number of transactions. 2) POS blocks don't impose a cost for the validation node.