The Effects of the Luxury Tax

Major League Baseball’s general managers are meeting in Palm Springs, Calif., this week, which kicks the Hot Stove burner from simmer to medium-low. The burner will turn to high next month at the Winter Meetings in Nashville.

Even on simmer, there is word from the Bronx that the Yankees won’t pursue “big time” — or even “less-than-big-time” — free agents this winter, despite rotation and outfield needs. We can debate whether to accept the “word from the Bronx” as true or just a negotiating ploy. What we do know is this: Yankees owner Hal Steinbrenner has said repeatedly that he wants to bring the Yankees below the $189 million luxury tax threshold in 2014. Why? Well, that takes some explaining.

The luxury tax is a shorthand term for the Competitive Balance Tax provisions in the Collective Bargaining Agreement. It imposes a penalty on teams with player payrolls above a set threshold.  The tax is levied only on the portion of a team’s payroll that exceeds the predetermined amount. The luxury tax was first introduced in the 2003-2006 CBA and was designed to keep player payrolls from skyrocketing, without setting a hard salary cap.

The current CBA covers the 2012 through 2016 seasons and sets the following payroll thresholds for each year:

2012: $178 million
2013:  $178 million
2014: $189 million
2015: $189 million
2016: $189 million

So, for example, if a team’s payroll for 2012 was $185 million, that team would be taxed on $7 million ($185 million – $178 million). But what’s the tax rate? That depends. The rate is tied to a team’s luxury tax history. If the team wasn’t assessed a tax in the prior season, then the tax rate is 20%. If the team paid the luxury tax in 2011 at a 22.5% rate, then the tax rate for 2012 is 30%. A 30% luxury tax rate in 2011 would yield a 40% rate for the same team in 2012. And a 40% luxury tax rate in 2011 would mean a 42.5% rate in 2012. For the seasons 2013 through 2016, the initial rate goes down (from 20% to 17.5%), the 30% and 40% tax rates stay the same and the 42.5% rate shoots up to 50%.

Which brings us back to the Yankees and its 2014 payroll.

The Yankees have paid the luxury tax every season since the tax’s inception. In 2011, the Yankees’ tax rate was 40% — the highest possible rate under the previous CBA. That means the team’s tax rate in 2012 is 42.5% and will be 50% in 2013. But if the Yankees keep payroll below $189 million in 2014, it not only avoids the tax that season, but it also lower the team’s luxury-tax rate for 2015 to only 17.5%. That’s right, avoiding the luxury tax for just one year re-sets a team’s tax rate to the lowest under the CBA. Even for the Yankees, the difference between a 50% tax rate and a 17.5% tax rate is significant.

By steering clear of free agents looking for more than one-year deals, the Yankees are well-positioned to get below the $189 million threshold in 2014. The team only has three players under contract in 2014 — CC Sabathia, Alex Rodriguez and Mark Teixeira — and while those three players add up to more than $70 million in salary, that’s still less than 40% of the luxury tax threshold.

But why not just sign free agents to backloaded contracts? Well, the Yankees could, but it won’t help them on the tax front. That’s because multi-year contracts are given an average annual value (AAV) for assessing the luxury tax, meaning a contract that calls for $10 million in Year 1, $12 million in Year 2, $15 million in Year 3, and $20 million in Year 4 counts as $14.25 million toward the threshold each season. Signing bonuses are also added in to figure out a contract’s AAV.

Then there’s the matter of options. My colleague Eric Seidman explained this issue well over at Phillies Nation in a discussion about Cole Hamels‘ contract extension:

Both vesting and club options are excluded from the calculation, while player options are factored in. If a vesting option vests or a club option is exercised, the salary is treated like a one-year deal for the luxury tax. There is also the issue of timing: If an extension is worked out before a current deal expires, the contracts are consolidated.

Ryan Howard is a perfect example of said consolidation. He was signed to a 3 yr/$54 million contract, and then signed his monster 5 yr/$125 million contract. But because he signed the five-year pact before the initial deal expired, the luxury tax views his contract as 6 yrs/$143 million, for an average annual value of $23.8 million. While that is a bit of a discount relative to the 5 yr/$125 mil deal, it means the Phillies paid almost $6 million more for Howard when calculating luxury tax payroll last year.

But wait, there’s more!

To determine if a team exceeds the tax threshold, you need to do more than simply add up the AAVs of major-league contract for that season. Under the CBA, each team’s payroll also includes a 1/30th share of player-benefit costs: things like contributions to the pension plan, workers compensation premiums, spring training allowances, moving expenses and player medical costs. For 2013, each 1/30th share is valued at $10,799,590. That figure will rise in 2014 and beyond.

For years, the luxury tax could have been called the Yankees-Red Sox tax, as those two teams were the only ones that consistently exceed the threshold limits. And by being repeat offenders, the Yankees and Red Sox faced escalating tax rates. That’s why the Yankees are trying to draw the line for 2014.

That’s not the case for the Los Angeles Dodgers.

New owners spent $2.15 billion to acquire the Dodgers from Frank McCourt earlier this year and then poured millions more into the team through the trade for Adrian Gonzalez, Josh Beckett, Carl Crawford and Nick Punto last August. EPSN’s Jayson Stark wrote yesterday that the Dodgers’ 2013 payroll already exceeds $180 million and that team is looking for further upgrades, whether by trade or free-agent signing. If so, the Dodgers will trigger the luxury tax for the first time next season, leading to a 17.5% tax the difference between $178 million and the team’s final payroll. According to Stark, the Dodgers don’t appear to be the least bit concerned about paying a luxury tax. They want to be build a perennial winner, and if it takes spending over the threshold in 2013 and later, so be it.

Sounds familiar, huh? That’s precisely the way the Yankees did business for years. Now, 10 years after the luxury tax was put in place, the Yankees are showing financial restraint. Whether the Dodgers will spend and spend for 10 years without concern for the luxury tax remains to be seen. But for now, it appears the Yankees have ceded the big money powerhouse label to the Dodgers. Well, at least until 2015.




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Wendy also writes for Sports on Earth and Bay Area Sports Guy. She's written for ESPN.com, Baseball Nation and The Wall Street Journal. Wendy practiced law for 18 years before pursuing her passion for baseball. You can follow her writings and ravings on Twitter @hangingsliders.

33 Responses to “The Effects of the Luxury Tax”

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  1. Ian R. says:

    Shedding payroll for one year just to reset the luxury tax clock, as it were, seems like a serious exploit of the system on the Yankees’ part. Unabashedly so, even.

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    • Steve says:

      How so? They are following the rules to the letter. How is that an “exploit”?

      Also, who said they will jump their payroll back up in 2015?

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    • Solidarity says:

      The provision is in place to allow forgiveness for offenders and thus give them an incentive to stay within striking distance of the cap. Even if they don’t -need- to stay below the cap, it becomes more beneficial to do so.

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  2. indyralph says:

    I thought this post was very informative, so pardon me for starting the thread with a criticism. But the paragraph starting “So, for example” is clear as mud. I think it says that in calendar years 2012 and prior, the progression of rates was 20, 22.5, 30, 40, 42.5% for each year above the threshold. Then in 2013 this changes to 17.5, 22.5, 30, 40, 50%. Am I reading this right?

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  3. TKDC says:

    How are players that are acquired midseason via trade or free agency treated? Is it pro rata?

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  4. TKDC says:

    Wouldn’t a team be advantaged by including player options that a player would most likely not take? Like if you sign B.J. Upton to a 5/80 million dollar deal, why not throw on a 1-year option for 1 million? That way, instead of being AVV of 16 million, it would be an AVV of 13.5 million(6/81). Sure, if Upton is worthless in 5 years (unlikely), he would take the 1 million, but it could be a risk worth taking.

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    • brian says:

      This is exactly what the Red Sox did with Adrian Beltre’s contract, I think the option was a more reasonable $3m though.

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    • RSquared says:

      If Upton turned down the player option year of $1MM, the payroll hit for that option year would be $15MM (difference between the AAV of the 5 guaranteed years and the player option year), against the CBT threshold. Doesn’t seem worth it.

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  5. Nick V says:

    So the Yankees should absolutely extend Cano right now as opposed to letting him go to FA (assuming Boras wouldn’t reject a market-appropriate extension of, say 9/225).

    Let’s say he’d sign as an FA for 9/225. If the Yankees made that an extension, it’d be that, plus his previous deal, which is 6/59, including the two options. So instead of a 25M AAV, it’d be a 15/284 deal, or ~19M AAV.

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    • TKDC says:

      I think it only counts the remaining years on the deal. So it would be 10 years at 225 plus whatever Cano makes in 2013.

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    • brian says:

      If the Yankees are intent on getting under the tax, signing Cano to that deal makes it very difficult to field a contending team around him, Sabathia, Teixeria, and Rodriguez. It leaves about $85m for the remaining 21 spots, and the Yankees system lacks near ready impact prospects.

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      • Nick V says:

        I think it’s a lot less likely that the Yankees care so much about the 189 figure that they’d let Cano, their best player, walk. And walk he will if they don’t give him top dollar. You don’t sign on with Boras to get a team friendly deal.

        I think the Yankees are saying, loudly and often, that they need to get under the 189M figure. And they’ll likely do what they can with regard to the 2014 team to get there, but it certainly won’t keep them from extending Cano.

        In the end, I don’t believe the Yankees will make it under 189M for 2014. Jeter picking up his option will greatly increase their payroll, and you’re right that their prospects aren’t likely to be ready for prime time to fill in major gaps (maybe Austin and Williams can make up 2/3 of their OF along with Brett Gardner, and maybe Gary Sanchez will be ready. And maybe a couple of their pitchers can be at least cheap bullpen guys. However, I’d say expecting any of those outside of possibly Austin would be foolish). And with the money that’s out there, even the middle-of-the-road FAs are probably going to get good-sized deals.

        It’ll be a very interesting couple of years to watch that team’s machinations…

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      • Steve says:

        Jeter’s option is $8M, isn’t that a net decrease of $9M?

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      • Nick V says:

        Yes, it would decrease relative to the previous year, but I mean that it would increase the payroll from the 3-4 players they’d have already on the books (CC, Teix, ARod, and possibly Cano).

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      • Julian says:

        Since Jeter has a player option, if he accepts it it will be as if he had just signed a 4-yr deal. But since his $8 million player optn is worth less than the AAV of the contract, him rejecting it will also cost $ for the Yankees (with the difference being around 9 million).

        So, essentially, it’s a wash–either the Yankees pay him $8mil for luxury tax purposes in 2014, or $9mil

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    • Cliff says:

      9/225 is not market appropriate because no team, including the Yankees, will pay that. That would be one of the worst contracts of all time.

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  6. Leith Kaw says:

    So, as I understand it, if the Dodgers are really, really loose with their money this offseason, and wind up exceeding the luxury tax threshold by, say, $30M, they’ll only be taxed 30 X 17.5%, or a bit over $5M bucks?

    No wonder they don’t care, given that they spent 403 times that, to acquire the team.

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  7. Bob says:

    Very nice article. Thanks, Wendy!

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  8. RSquared says:

    More importantly the amount of revenue sharing rebated under the 11-16 CBA to payor clubs is tied to the CBT. Payor teams are rewarded with a bigger chunk by staying under the CBT for consecutive years, beginning particularly in 2015. Since NYY is the biggest payor, this is significant.

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    • Joe says:

      Yes this is what is really driving the payroll level under 189 and is why this will likely be a 2 year plan (2014/15) and not just an attempt to get under it in 2014 to reset the tax rate.

      The estimates are all over the place but I’ve seen 40-100mil tossed around on the web. Even at a 50% rate if the Yankees are in the 200-210mil payroll range, it’s still ‘just’ 5-10mil/yr in terms of luxury tax. The revenue rebate is supposedly much bigger than that.

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  9. tbjfan says:

    How are buyouts included in the calculations?

    Eric Seidman’s explanation doesn’t fully explain things.

    For example, consider this scenario:
    I am a free agent. I sign for 3yr/$33m which includes a club option. Let’s say the breakdown is as follows:
    - Year 1: $10m
    - Year 2: $10m
    - Year 3: $10m
    - Year 4: $10m with a $3m buyout.

    So the AAV would be $11m a year for 3 years?

    But if the team exercises the option, the tax-impact would still be $10m for year 4.

    So isn’t the buyout actually double-counted?

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    • Michael says:

      I think this is how it works.

      In your scenario, the contract would count as a 4-year/$33m deal, as long as the option isn’t yet picked up. So the AAV hit to the luxury tax would be $8.25m for each of the first three years.

      In the fourth year, if the option is bought out, the luxury tax hit is again $8.25m, even though the player isn’t on the roster. If the option is picked up, however, the deal transforms into a 4-year/$40m contract, and there’s some back-taxing in order. The hit to the luxury tax that year starts with the new AAV of $10m and gets added to it $1.75m for each of the first three years, which wasn’t accounted for. So as far as the luxury tax is concerned, the deal ends up being
      - Year 1: $8.25m
      - Year 2: $8.25m
      - Year 3: $8.25m
      - Year 4: $15.25m

      The general principle here is that by the end of the contract, the salary as reckoned for luxury tax purposes has to match the total salary actually paid. And adding an option year with buyout to the end of a contract is a way of backloading the impact of that contract on the luxury tax.

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      • nyyfaninlaaland says:

        Actually I don’t believe this is how it goes.

        As Wendy said, option years are treated independantly. So in the example the AAV in years 1 -3 is $10 mm. Then in year 4 it is $10 mm if picked up, and $3 mm if not.

        In other words, buyouts count as an added “sunk cost” in the option year.

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  10. Mamayuen says:

    Great article, Wendy.

    Forgive me for asking a simple question. Is this luxury tax paid to the govt or is this the fee that goes to the league distributed amongst the lower tiered teams.

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    • nyyfaninlaaland says:

      Neither.

      The Luxury tax payments go to MLB to cover things like promotion of the game and past player retirement benefits to my understanding.

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  11. Owen says:

    Nifty post!

    At last I know why my Mets are keeping their payroll at $80 million. (snark only directed at Wilpons, none at all to Sandy or Wendy)

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  12. Bryce says:

    This would explain the Yanks interest in Beltran whose contract ends after 2013.

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  13. Andrew says:

    I never thought that coming to a baseball website I would be able to find discounts on N-ike s-hox, TL3′s no less!!! (whatever the f*ck those are). Thanks Jiaonizuo!

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