MLB’s Evolving Luxury Tax

A few weeks ago I took a look at Major League Baseball players’ declining share of overall league revenues, noting that the players have gone from receiving just over 56% of MLB’s revenues in 2002 to around 38% today. That post went on to identify a variety of factors that have converged to reduce the percentage of league revenues going to the players, including increased revenue sharing, MLB’s growing television revenues, and more efficient front office decision-making.

One factor that I touched upon briefly in my prior post, but that probably merited a more extended discussion, is MLB’s luxury tax. As I explained the last time around, the luxury tax has helped dampen many of the larger market franchises’ willingness to spend on payroll, as teams will now incur a fine ranging from 17.5% to 50% – depending on how many years in a row the club has exceeded the luxury tax threshold – for every dollar they spend on player salaries over $189 million per year.

Because most clubs will only raise their payroll when they anticipate that each additional dollar spent on player salary will generate more than that in added revenue, the luxury tax provides a natural disincentive for most teams to cross the payroll threshold. Now, rather believe that an extra dollar in payroll will generate at least $1.01 in added revenue, teams must instead anticipate that any increased salary obligations above $189 million will generate anywhere from $1.18 to as much as $1.51 per dollar in new revenue in order to justify the expenditure. As a result, the luxury tax has caused most of MLB’s largest market franchises – the teams that the Major League Baseball Players Association has historically relied on to help drive the free agent market – to become more financially prudent in recent years.

But even this basic account doesn’t fully reflect the impact that the luxury tax has had on the players’ declining share of league revenues, as changes to the luxury tax structure since 2002 have increased the penalties for teams exceeding the payroll threshold, while also significantly lowering the threshold as a share of the average MLB team’s revenues.

The luxury tax was originally created in MLB’s 1996 collective bargaining agreement, which was signed in the aftermath of the 1994 strike. The tax was intended to serve as a compromise between players and owners, providing a check on the highest spending teams’ payrolls without creating the sort of official salary cap that the players have historically objected to.

In its initial form, the luxury tax imposed a 34% fine on each dollar a team spent over the midpoint of the fifth and sixth highest team payrolls. So, in other words, the five highest payroll teams each had to pay an additional 34 cents for every dollar they spent on player salaries above the average of the fifth and sixth highest teams’ payrolls. This initial version of the luxury tax was only approved for the 1997, 1998, and 1999 seasons, however, so no penalty was enforced during the 2000 through 2002 seasons.

The 2002 CBA reintroduced the luxury tax – technically now named the “competitive balance tax” – for the 2003 season. The 2002 agreement tweaked the prior formula in two ways, establishing the basic framework that remains in place today. First, the 2002 CBA created a fixed payroll threshold for the luxury tax, replacing the floating figure used from 1997 to 1999. This threshold was subsequently increased in both the 2006 and 2012 CBAs, as detailed below:

Year Luxury Tax Threshold
2003 $117,000,000
2004 $120,500,000
2005 $128,000,000
2006 $136,500,000
2007 $148,000,000
2008 $155,000,000
2009 $162,000,000
2010 $170,000,000
2011 $178,000,000
2012 $178,000,000
2013 $178,000,000
2014 $189,000,000
2015 $189,000,000
2016 $189,000,000

In addition, the 2002 CBA also introduced a progressive penalty scale for teams that repeatedly exceeded the luxury tax threshold. Under both the 2002 and 2006 agreements, first time violators were charged a 17.5% to 22.5% tax, second-time offenders a 30% tax, and three-time violators a 40% tax. An additional penalty level was added in the 2012 CBA, taxing teams that exceed the threshold for four or more years in a row at a 50% rate.

This evolving luxury tax framework has contributed to the reduction in the players’ share of overall MLB revenues in several ways. First, and perhaps most importantly, the fixed payroll thresholds have failed to keep up with MLB’s growing league revenues. While the luxury tax threshold was originally set at 90% of the average MLB team’s annual revenue in 2003, it has dropped to only 63% today:

Luxury Tax as Share of MLB Revenue

(Average revenue equals MLB’s total estimated annual league revenue divided by 30; estimated annual league revenue data from BizofBaseball.com)

In 2003, for example, the $117 million luxury tax threshold was just $13 million under the average MLB team’s annual revenue of $130 million. By 2014, that gap had increased to $111 million:

Luxury Tax Average Rev

(Data same as above)

Even this comparison doesn’t tell the entire story, however. The primary purpose of the luxury tax was not – at least originally – to restrict the spending of the average MLB revenue team, but instead to curb the spending of MLB’s highest revenue franchises. Because the largest market teams generate revenue figures well above the league average, this means that the revenue gap between the luxury tax threshold and the teams it was primarily intended to restrict is now, in fact, much larger.

Take the Yankees, for example. From 2000 until 2005, New York’s payroll increased at approximately the same rate as the team’s estimated revenues. As soon as the Yankees faced a 40% penalty as a three-time violator under the new luxury tax framework adopted in 2006, however, the team’s payroll effectively flatlined. This has remained true up to today, even though the Yankees’ estimated annual revenues almost doubled from 2005 to 2014. As a result, today the luxury tax threshold is set at a level approximately less than 40% of New York’s estimated annual revenues:

Yankees Payroll and Estimated Revenue

(Team payroll data from Cot’s Contracts; estimated team revenue data from BizofBaseball.com and Forbes (2012, 2013, and 2014))

The data for the Red Sox paint a similar picture. Although Boston’s estimated revenues rose by approximately 40% from 2007 to 2014 (going from $263 million to $370 million), in order to stay below the luxury tax threshold the team only increased its payroll by roughly 10% during this same time period (rising from $147 million to $163 million, a $16 million difference):

Red Sox Payroll and Estimated Revenue

(Data same as above)

There has, of course, been one notable exception to this trend in recent years, as the Los Angeles Dodgers have been willing to blow through the luxury tax threshold following the team’s sale back in 2012:

Dodgers Payroll and Estimated Revenue

(Data same as above)

Even then, though, the Dodgers’ payroll has not kept up with the rapid growth in the team’s estimated revenues over the last couple years. Moreover, a sizeable portion of Los Angeles’ increased payroll has come through the assumption of existing salary obligations from other franchises – Adrian Gonzalez, Carl Crawford, etc. – meaning that the Dodgers’ recent spending spree has not elevated the market for players’ salaries as much as one might normally expect. Instead, it is largely helping to reduce other teams’ payroll obligations.

Overall, however, it appears that the luxury tax threshold has effectively become a de facto salary cap for many of MLB’s larger market teams, and thus represents an important contributing factor to the players’ declining share of MLB’s overall league revenues.

The luxury tax’s effect on the large market teams is especially problematic for the MLBPA, as the union has traditionally relied on these clubs to sign players to lucrative free agent contracts, driving up the market for player salaries overall. These gains have, in turn, historically trickled down to the rest of the union membership through both the salary arbitration process and by forcing the rest of the league to increase its spending to keep up with the highest revenue franchises. With the luxury tax causing teams like the Yankees and Red Sox to show more financial restraint, however, the effectiveness of the MLBPA’s traditional strategy is now in doubt.

In hindsight, then, the MLBPA likely made a mistake by agreeing to a more restrictive luxury tax framework in the last several CBAs. And to the extent the union intends to address the players’ declining share of overall league revenues in the 2016 collective bargaining negotiations, modifying the luxury tax will likely prove to be an important piece of the puzzle.

From the players’ perspective, the next CBA would ideally both significantly increase the luxury tax threshold and substantially reduce the penalties that teams face for repeatedly exceeding it. The owners, however, are likely to oppose any major changes to the luxury tax framework – and its penalty structure in particular – since the existing model has proven to be quite beneficial. And considering that the players have agreed to a fairly severe series of escalating penalties for more than a decade, it may now very well be too late for them to realistically hope to significantly reduce the luxury tax rates in the next CBA.

The more realistic approach for the players, then, is likely to be focusing their efforts on raising the luxury tax threshold. While the players could obviously simply agree to a more substantial set of predetermined increases to the threshold, they may be better off attempting to have the payroll limit established each year based on a fixed percentage of MLB’s estimated overall league revenues. This would help the players avoid seeing their share of revenues lag during the course of a multi-year CBA should the league’s profits end up growing at a faster pace than the union had expected, as may have been the case in recent years.

Whether or not this is an obtainable goal for the MLBPA, however, is difficult to predict. And even if it is achievable, it’s also unclear just how much of an impact such a change would have on the players’ declining share of league revenues overall. So considering that the owners would almost certainly demand some significant concessions in exchange, it’s quite possible that a floating luxury tax threshold may prove more costly for the players than it is worth.

One way or another, though, if MLB players hope to obtain a larger share of league revenues, they will likely look to change the luxury tax framework in the next CBA.



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Nathaniel Grow is an Associate Professor of Legal Studies at the University of Georgia's Terry College of Business. He is the author of Baseball on Trial: The Origin of Baseball's Antitrust Exemption, as well as a number of sports-related law review articles. You can follow him on Twitter @NathanielGrow. The views expressed are solely those of the author and do not express the views or opinions of the University of Georgia.


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Adam Blosser
Guest
Adam Blosser
1 year 28 days ago

I would prefer to see a significant increase to the major league minimum salary. That would cause the percentage of revenue going to the players while still maintaining the luxury tax’s parity benefits.

Yirmiyahu
Member
1 year 28 days ago

While increases to minimum salaries would probably be more popular with the player’s union (most baseball players do not receive the enormous contracts that would affect a team’s luxury tax decision-making), it would be equally unpopular for all 30 MLB owners.

As far as the luxury tax, you’d want to craft something that could get the support of a majority of owners. The “upper middle class” teams might be willing to support a change because they’re currently butting up against the luxury tax thresholds when the system wasn’t really designed to punish them. The poorer teams like the luxury tax because it creates revenue sharing money, and they wouldn’t want to see that revenue decrease, so maybe you can balance things out by increasing the luxury tax penalty rates.

Eric R
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Eric R
1 year 28 days ago

That would cost small payroll teams far more than big payroll teams.

Lets say you raised the minimum to $2M from $500k. A large market team like the Dodgers with 22 guys making >$2M would add less than $5M to their payroll. that is like an extra 5%.

The Astros only have 13 guys at >$2M, so would add like $15M… which would be about an extra 20%.

BMarkham
Guest
BMarkham
1 year 28 days ago

I think it’s a good idea to raise the minimum salary, but I disagree that it would help parity. The smaller market teams (as well as mid-market teams) have benefited big time from the cost savings associated with having average or better players making so little a year (in baseball market terms of course, i’d love to make half a million a year). It would also provide a disincentive for those players to take the cheap extensions they’ve been taking lately. The small market teams have saved a lot of money on their pre-arb and arb players which has allowed them to invest at least small amounts in free agency contracts that they wouldn’t have been able to spend had the minimum salary been higher.

Again, as a Baseball fan I still think more money should be going to the players instead of the owners, but I just disagree it would offer more parity.

Perhaps if it was done in conjunction with payroll floors and more revenue sharing it could work. The MLB has more parity than it did in the late 90s/early 2000s, but if it wants to increase it from here it’ll probably have to emulate the NFL more.

Matt P
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Matt P
1 year 28 days ago

It could be just as likely that the Yankees and Red Sox have decided that spending a lot of money on aging free agents is a bad strategy. And indeed there’s a lot of evidence that the Red Sox have learned just that.

It doesn’t help that the Yankees’ closest thing to a hometown star is Brett Gardner.

mtsw
Guest
mtsw
1 year 28 days ago

I wonder how much of this has to do with the lower average age of MLB players and an increasing awareness of the importance of defense. In a way that wasn’t true 15 years ago,

I think most teams now recognize that the league’s most valuable players are largely guys who are still young enough to still be under team control and that bidding on signing 31-year-olds to 8 year deals is a losing strategy. Would we see an epic bidding war if someone like Trout or Stanton or Kershaw actually became a free agent? The closest thing we had this offseason was Scherzer who is arguably not even one of the league’s 10 best pitchers and was already 30.

If the goal is to raise the share of revenues going to players it’ll be just as important to give young stars avenues to enter free agency earlier or reform the arbitration system to more accurately reflect the market value of young stars as it would be to meddle with the luxury tax, in my opinion. Whether that will happen or not is an open question, since the MLBPA seems to disproportionately represent the interests of veteran players against young ones.

That Guy
Guest
That Guy
1 year 27 days ago

Scherzer? He /did/ prompt a bidding war, and he’s a top ten pitcher, almost unarguably elsewise…

carter
Member
carter
1 year 27 days ago

It is possible he is not a top 5 pitcher, but he is assuredly a top 10 pitcher.

Will
Guest
1 year 28 days ago

I don’t quite get the suggestion that the MLBPA “made a mistake” when its members have prospered so greatly? Over the long run, MLB players have done very well, so just because short-term percentages favor the owners, doesn’t mean the MLBPA should pursue a fundamental shift in philosophy. As note, increasing the threshold is likely, but that would be part of the natural course anyway.

Finally, what I think the Yankees and Red Sox behavior reveals is lessening elasticity of revenue to winning, and therefore less commitment to spending commensurate sums on payroll. In other words, they use the luxury tax as an excuse to not spend, even though their revenue growth suggests a capacity to absorb increased payroll, even with the associated luxury tax hit.

BMarkham
Guest
BMarkham
1 year 28 days ago

“I don’t quite get the suggestion that the MLBPA “made a mistake” when its members have prospered so greatly? Over the long run, MLB players have done very well, so just because short-term percentages favor the owners”

What makes you think its the short term? Of course the players have prospered, the point is that the owners have prospered more. And the graphs make it clear that it’s an obvious trend, not some short term fluctuation. And you don’t have to take an economic class to understand that additional taxes past a certain level is going to limit spending.

“Finally, what I think the Yankees and Red Sox behavior reveals is lessening elasticity of revenue to winning,”

Considering the fact that the Yankees haven’t won anything lately even though their fans are probably the most insistent on winning in all of sports, that is a pretty dubious statement.

William
Guest
1 year 28 days ago

What makes me think that are the numbers, which show that the owners increasing percentage of industry revenue is a recent phenomenon (mostly because of exploding revenue from TV contracts). If the MLBPA believes that salaries will eventually catch up as teams spend more of their largess (and there are indications that is taking place), then it would be foolish to deviate from a philosophy that has proven very prosperous over a much longer period of time.

As for the Yankees, the team has sold a big equity stake in YES, inked a 30-year rights fee, and established what appears to be (based on the yearly financials filed pursuant to the team’s PILOTs)a very stable season base. In other words, as long as the Yankees maintain a level of respectability and brand integrity, they do not to win as much as they have in the past.

BMarkham
Guest
BMarkham
1 year 27 days ago

These are long term deals though right? Like 20 years? Seems like they’re going to long-term, not just some short term bubble.

Patrick OKennedy
Guest
1 year 28 days ago

There is no competitive balance tax (luxury tax) when the current CBA expires. Further, there is a sunset provision in the current CBA that prohibits a tax in future years, beyond this current term.

ARTICLE XXIII, SECTION I
I. Sunset
There shall be no Competitive Balance Tax in place following the 2016
championship season, and the Parties expressly acknowledge and
agree that the provisions of this Article XXIII (except those concern-
ing the collection and distribution of the Competitive Balance Tax pro-
ceeds for the 2016 Contract Year) shall not survive the expiration of
this Agreement.

Now, everything is negotiable, but the plain language of this sunset provision is pretty clear. The parties have agreed that there will be no luxury tax in the next CBA.

The players don’t have to worry about trying to increase the tax threshold. It’s gone. What some folks have to be concerned about is larger market clubs being unshackled, free to spend as much as they like without limitations due to any spending tax. How do they maintain “competitive balance” in that situation?

The obvious approach would be to go after the revenue sharing formula. Presently, 34% of local revenues go into the pool to be shared. Say that goes up to 50%? Every local dollar from gate receipts, television, concessions and parking is spit, 50/50. Home team gets half and half goes into the pool to be split 30 ways.

That might be something that will make larger market clubs yearn for the days of the luxury tax.

Yirmiyahu
Member
1 year 28 days ago

It is a bit odd. If the CBA expires, all the rules in it expire as well, so it’s kind of strange that there’s such strong language specifying that this particular provision dies with the CBA. And an expiring contract can’t forbid something in a future contract. So, legally, I don’t see it having any meaning whatsoever.

But for practical purposes, at the expiration of an agreement, the parties don’t really work from a vacuum. They work from an understanding that the rules will stay the same unless there’s a reason for a party to change them, and that usually takes compromise. So I’m guessing the union has had that language stuck in each time because they want to work from a bargaining position where there is no luxury tax, and then they agree to a luxury tax in exchange for MLB granting them some other concessions.

Pat
Guest
Pat
1 year 25 days ago

Thats not what it means. It has to do with CBA negotiations and if they play a season without a new CBA or the owners try to declare an impasse. It doesn’t signal the intent of the next CBA since that is a new negotiation.

Erik
Guest
Erik
1 year 28 days ago

I would like to see a more market based approach to arbitration.

Start it a year earlier, eliminate the arbitration board and force teams to make competitive offers to their players or risk losing them to teams willing to over pay.

Lanidrac
Guest
Lanidrac
1 year 27 days ago

You can’t force a team to make an offer (called non-tendering), and otherwise what’s the difference between this and free agency? The owners would never agree to ceding four years of team control.

Patrick OKennedy
Guest
1 year 28 days ago

I thought of that too, William. But then, why only this provision that has the sunset clause? Everything points to this being an agreed intent to let the tax expire.

I have always looked at the luxury tax, as well as salary caps in other sports, as a bad idea— whose time has come. Something of a necessary evil. In an industry where competition IS the very essence of the business, competitive balance is essential to the success of the business.

The NFL divides the lions’ share of it’s revenues between the 32 teams, because their national TV revenue is all in national contracts with the national networks. Baseball is the opposite. The national networks are barely interested in any coverage during the season. The National TV contracts give each club a bundle of money, but the local TV deals are what is creating the huge disparity in revenues. I really think they have to work on distributing those revenues more evenly, with or without spending limits. It takes two teams to put on the show.

William
Guest
1 year 28 days ago

Perhaps another reason why the clause is included is to emphasize that every new CBA begins fresh when it comes to a luxury tax (i.e., the owners have to re-justify it, instead of the MLBPA having to debunk it). This might, in a small way, lessen the leverage owners would have because the MLBPA would not have to bargain away something in return for it repeal. Of course, that doesn’t mean an emboldened ownership group wouldn’t take that tact anyway.

I disagree completely on the merits of salary caps and luxury taxes, especially in a sport like MLB that relies on its individual franchises generating revenue locally. Any disincentive to invest in the on-field product would be counterproductive, and that’s essentially what a salary cap does. I also think there’s a fine line between competitive balance and mediocrity, and for most sports (NFL being an exception because what I believe is the strong gambling influence), it’s better to error on the side of quality.

Patrick OKennedy
Guest
1 year 28 days ago

I agree in principle that salary caps are evil, but I fear the alternative to be worse. That extra investment in the on field product is going to create further imbalance between the quality of richer teams vs poorer teams. I don’t think that the clubs that are close to paying a luxury tax have to worry about mediocrity due to the tax. If they’re in that tax bracket with a mediocre club, they’ve made some pretty bad moves.

The NFL has a salary cap in the interest of owners’ profits. It has nothing to do with competitive balance. They also have a much weaker union, traditionally.

One thing that I think we can count on in the next round- at a minimum, the players and larger market clubs will want an increase in the tax threshold, if not its’ elimination entirely, and if there is a tax, they’ll want an automatic reset of the trigger, starting with the new agreement.

I do think that we have a few clubs- Boston, Philly, and Detroit, and maybe the Angels, whose player signing decisions are influenced by the existence of the tax. I don’t see that as a good thing. But I wouldn’t want to see the Dodgers and Yankees unshackled without some sort of balancing provisions, preferably on the revenue side of the ledger.

BMarkham
Guest
BMarkham
1 year 28 days ago

“The NFL divides the lions’ share of it’s revenues between the 32 teams, because their national TV revenue is all in national contracts with the national networks. Baseball is the opposite. The national networks are barely interested in any coverage during the season. The National TV contracts give each club a bundle of money, but the local TV deals are what is creating the huge disparity in revenues. I really think they have to work on distributing those revenues more evenly, with or without spending limits. It takes two teams to put on the show.”

This is true, but it can change if blackout rules are struck down and MLB.tv grows. That’s a long shot in the present, but I think that the current situation will eventually evolve towards that.

Patrick OKennedy
Guest
1 year 28 days ago

To his credit, Bud Selig and his administration have done quite a bit to grow revenue streams that are divided among all 30 clubs. Some are divided unevenly through the revenue sharing scheme.

That includes “out of market” television revenues from sources like DirecTV, MLB.tv, as well as MLB Advanced Media which is a huge cash cow. But the local revenue deals are still the biggest source, and the broadcasts on the out of market channels are from the stations that have contracts with local teams.

The more that revenues come from national or out of market sources, the more level the playing field. But it’s the local TV deals that have been growing in terms of dollars recently, more than anything. It is evolving.

BMarkham
Guest
BMarkham
1 year 27 days ago

yes, I agree with pretty much all of this. I just think at some point the all-you-can-eat cable package goes away, and Baseball fans move on to purchasing MLB.tv. Live sports is the only thing keeping the model going right now, and as long as MLB.tv has a strong product team they will eventually build a version that is way better than passively watching a static TV broadcast. It might take a while of course.

pft
Guest
pft
1 year 28 days ago

Great article. So whats the MLBPA leadership doing, smoking crack?. Have they been co-opted by MLB leadership?. Players need to take a hard look at their leadership over the last 6 years or so, and although the leader responsible for the last CBA has died of brain cancer the current one is the weakest union head one could imagine

Patrick OKennedy
Guest
1 year 27 days ago

I think it’s a bit premature to judge Tony Clark’s leadership of the MLBPA. He has yet to have a real issue arise where strong leadership has been required. All the action has been on the owners’ side since he took over, and the owners now have a commissioner who is more flexible with the players, as opposed to Jerry Reinsdorf’s hard liners who would lock the players out to get a hard salary cap. It was best for the players to sit it out and let Manfred slide into his chair.

The next round of CBA talks will be interesting. Last time around, a deal was done before there was any sign of negotiations. There were some significant changes in the areas of drug testing, free agent compensation, super two eligibility, and a nice bump in the minimum salary.

Next round, the owners will want an international draft, and they’re likely to get it, because the current MLBPA membership have nothing to lose, personally. It’s a matter of what they get in return. The status of the luxury tax is one issue, and if it’s perceived that the tax causes restraint among a number of teams, that impacts more than just the highest paid players, as Nathaniel points out. The owners have more money than ever to spend, and the players will want a cut.

carter
Member
carter
1 year 27 days ago

Is there zero chance any sort of deal is ever worked out to increase minor league player minimums?

Reade King
Guest
1 year 27 days ago

Well, that will only ever happen if the MLBPA decides to organize the minor league players. If they were a real union and not just a skilled-worker guild, they would have long since done so. However, significantly larger amounts of money paid to the minor leaguers would probably no be seen as in the Major League players’ interest…

1smoothoperator
Guest
1smoothoperator
1 year 26 days ago

Do away with all luxury taxes and salary caps. The team owners should spend as they want as they own the teams. Free market works the best for the teams, plyers, owners. If you like the taxes penalty fees and salary caps—-move to moscow buy a team their and hang out with the commie komrads.

Spa City
Member
Member
Spa City
1 year 26 days ago

I am all for the free market. But I suspect a true free market approach to MLB would result in 4 teams each in NY, LA, Chicago, SF, Boston and Houston… with no other teams.

Sandy Kazmir
Member
Sandy Kazmir
1 year 26 days ago

Great read. I wonder what your thoughts on the expanded “playoffs” effect. It has to further work to suppress salaries, but I’d love to hear the communtiy’s thoughts.

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