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.