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Explaining the Luxury Tax in Major League Baseball

There exist mechanisms in place in most American sports leagues to ensure that the league remains in a competitive balance and to prevent teams that operate in major markets (and thus have higher incomes) sign all the most talented players. Major League Baseball uses the Competitive Balance Tax, which is commonly called the Luxury tax, as a method to discourage teams from having huge payrolls that could result in the league being imbalanced.

The Luxury tax is different from other methods for limiting payroll as it doesn’t really prohibit big payrolls, as would be the case of a salary cap. What it does is imposing a penalty on the teams whose total payroll exceeds a certain amount previously defined on the Collective Bargaining Agreement (CBA).

The following are the luxury tax thresholds for the years covered in the current CBA

Year

Threshold

2012

$178 million

2013

$178 million

2014

$189 million

2015

$189 million

2016

$189 million

 

Any team whose payroll exceeds the threshold will be taxed a percentage of the exceeding amount.

Determining the tax rate

The tax rate is completely dependent on the team’s tax history. Teams that have been “repeat offenders” - hello New York Yankees - are subject to paying a higher tax rate.

This is how the tax rate will be calculated for clubs above the threshold in 2013 through 2016:

  • 17.5% if the team didn’t exceed the tax threshold in 2012
  • 30% if the team exceeded the tax threshold in 2012 and paid 20%
  • 40% if the team exceeded the tax threshold both in 2011 and 2012, meaning they paid 30% in 2012
  • 50% if the team exceeded the tax threshold in the last few years and they paid anything over 40%

Now, these percentages change with each new CBA, but the logic applied is usually the same. If you exceed the threshold, you’ll pay. If you have exceeded it for a few years in a row, you’ll pay more.

So, for example, if a team had a total payroll of $190 million in 2013 and they didn’t pay any tax the year before, they would be assessed a 17.5% tax over the $12 million (190 - 178) excedent, for a total of $2.1 million. If they had paid for the first time in 2012, they would have paid 30% (11.7 million),

Interestingly, though, avoiding the luxury tax for just one year resets the team’s tax rate. This is the main reason why the Yankees have been so quiet in the 2012-2013 offseason. They are pushing to lower their payroll below the threshold by 2014. After that, if they go again over the luxury tax threshold, instead of paying a 50% tax rate, they’d only pay 17.5%. That is a huge difference for any team.

Teams who have been over the threshold

Only four teams have exceeded the luxury tax threshold (by the end of the 2012 season): the New York Yankees, the Boston Red Sox, the Anaheim Angels and the Detroit Tigers. The Yankees have paid it every single year since its inception in 2003, which has led people to call it the ‘Yankees tax’.

Update: In 2013 the Yankees (50% rate) and Dodgers (17.5% rate) had to pay luxury tax.

Here is a breakdown of how much teams have paid since 2003:

Explaining The Luxury Tax Graph
For the upcoming 2013 season, the Los Angeles Dodgers

are taking a leaf out of the Yankees’ book as they have added millions in payroll with the addition of players like Adrian Gonzalez, Josh Beckett, Carl Crawford, Nick Punto, Zack Greinke, Hyun-Jin Ryu and possibly others to come. With this increase in payroll, they will for sure exceed the luxury tax threshold. At least for now, though, the owners are not very concerned with that.

What happens to the money gathered through this tax?

The money that is generated through this luxury tax is not distributed among the other teams in the league (which is what happens in the NBA). The first $5 million is kept for potential refunds. If there are no refunds, then that amount is contributed to the  Fund. The rest of the money is used as follows:

  • 50% is used to fund player benefits
  • 25% is used to fund baseball development in countries that don’t have high school baseball
  • 25% goes to the Industry Growth Fund


Now you know...

 


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