Competitive Balance Tax Complicates Teams’ Decisions During All Seasons

Last season, Clayton Kershaw earned approximately $34.5 million. On June 30th, the Dodgers placed him on the 15-day disabled list, and on August 3rd, Kershaw was moved to the 60-day DL (retroactive to June 30th). Nonetheless, Kershaw received a check of approximately $2.65 million every two weeks (MLB players are paid over the course of the regular season). And each time one of those checks was cut (a total of nearly $11 million while he was sidelined), it counted against the Dodgers’ Competitive Balance Tax threshold (“CBT”), also known as the “Luxury Tax”.

The CBT was first introduced for the 1997 season, and imposed a 34% tax on all monies spent above the average between the fifth and sixth largest team payrolls. That system lasted until 1999, and then the entire idea went on hiatus until the 2003 season. Beginning in 2003 — and still going today — a threshold level is set, and teams are charged if they have payroll in excess thereof. This removed any comparison to other teams. You spend, you pay.

Which takes us to the current Collective Bargaining Agreement, and the new thresholds. In 2016, the CBT was set at $189 million, and next season it will rise to $195 million. But, to truly understand the implications, you need to go inside the numbers.

Throughout the year, we follow a team’s salary obligations, with reporters providing fans with “real time” tallies of what a team is spending, how close they are to the “cap”, and the desire to avoid the Draconian penalties assessed if they go over (more about that below). But the figures we hear and read about can be deceiving, and they are very difficult to calculate.

Each November, a team of really smart people in the Commissioner’s office in New York tabulates each team’s prior season’s salaries. In theory, it is easy math. In theory. Here are a few rules:

  1. If a player has a multi-year deal, actual salary doesn’t matter — Average Annual Value (“AAV”) does. Even though Kershaw got paid $34.5 million, his AAV is only $30.7 million, so that is what counted against the CBT. In contrast, Giancarlo Stanton earned only $9 million last season, but his 13-year/$325 million contract has a $25 million AAV, which is what applied against the Marlins’ CBT.
  2. If a player goes on the DL and needs to be replaced (as the Dodgers did with Kershaw and the Marlins did with Stanton), they get no dispensation. The cost of any additional player is also applied against the CBT. If a team makes a trade, add the new salary. If they bring a guy up from AAA and need to give him a pro-rated minimum salary, that amount counts. Even if the team has an insurance policy on the player and receives reimbursement, the AAV still counts against the CBT.
  3. When a team picks up a player option, the actual salary paid counts against the CBT.
  4. All players on the 40-man roster are calculated in the CBT. Of course, the longer a player remains in the Minors, under the Minor League pay scale, the better for the team. But, as stated above, once that player is promoted and gets a minimum salary ($507,500 in 2016), the numbers need to be re-jiggered to accurately calculate the CBT amounts.
  5. Any mid-season acquisitions, including cash considerations moved amongst teams, are calculated in the CBT.
  6. When a player has certain incentives, performance bonuses, or awards rewards built into his deal, those, too, count against the CBT. So, the team must plan ahead for a player having a great season. While the Nationals were happy that Max Scherzer won the Cy Young Award last season, it cost them an additional $500,000 bonus, and an additional $500,000 hit to their CBT. Hopefully they planned ahead.
  7. But wait, there’s more. Each team has an annual bill for player benefits, health care, and the like. That comes to approximately $13 million per team per season. We never hear about this, which means that last season’s $189 million cap only offered about $176 million to spend. Those costs must be factored in as well.

When the MLB accountants and the team accountants exchange books, their numbers often vary. This is especially true for teams not accustomed to playing in the tall weeds. For instance, the Dodgers have at least four members of their staff assigned to salary cap issues — which makes sense as they deal with the CBT every season. A team like the Athletics or the Rays may not have anyone assigned to this task, as doing so would be akin to being having someone assigned to review Curt Schilling’s liberal Tweets.

So why is the CBT so important? Here is why, and it might help explain some of the (non)moves made by teams (such as the Red Sox) this off-season:

Next season’s CBT threshold is $195 million (about $182 million in salaries, but let’s not get too wonky). Under the new CBA, the first season a team goes over the CBT, they are charged an assessment of 20% of the overage, the second time, 30%, and each time thereafter, 50%. The analysis cannot stop there.

If a team is over by between $20-$40 million (i.e., by spending $215-$235 million next season), there is an additional 12% surcharge on the excess amounts. But, and this is the big “but”, when a team drops below the CBT threshold, they reset for future seasons.

Let’s take a look at the Red Sox, who were over the CBT last season. Let’s assume that once they set their 40-man, finish their arbitrations, and pay the player benefits, they are right at $195M (which is a reasonable assumption).

Now, many fans in the greater New England area were pushing the Red Sox to sign Edwin Encarnacion. And let’s assume the Red Sox could have closed the same deal as the Indians (3/$60 million). In 2017, Boston would be in its second season over the CBT, suffering a 30% tax (i.e., 30% of $20 million = $6M); in 2018 they would be in their third year, thus a 50% tax (the CBT goes up to $197 million, so only a $9 million hit (50% of $18 million over); and in 2019 they would also be assessed 50% (the CBT goes up to $206 million, so only a $4.5 million tax (50% of $9 million over). Assuming the Red Sox make no other deals that would push them into the surcharge, a $60 million deal for Encarnacion would actually cost the BoSox $79.5 million.

And, by doing so, they would severely limit their room to maneuver at the trade deadline and/or if they suffer any injuries. Many fans may still quibble with the Red Sox’ parsimoniousness, but at least there is a valid, long-term business reason why not to make that deal.

The CBT is complicated and ever-shifting. Teams have to be wary from the first day of the Hot Stove, until their final call-ups in September, all the way through Awards Season. One slip up can cost millions of dollars and have implications for multiple seasons.

So, the next time you hear Jason Heyman or Ken Rosenthal or Brian Cashman or Andrew Friedman wax eloquent about the Luxury Tax and its effect on teams, you will have a better understanding of what they mean, why it’s important, and how poor these teams really are.

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