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.

We hoped you liked reading MLB’s Evolving Luxury Tax by Nathaniel Grow!

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Nathaniel Grow is an Associate Professor of Business Law and Ethics at Indiana University's Kelley School 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 Indiana University.

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Adam Blosser
Guest
Adam Blosser

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

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
Guest
Eric R

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

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.