What Is Baseball’s Luxury Tax, Anyway?

[Ed. note: Those of you who frequent the comments know that LL is lucky to boast a stable of lawyers, which is both helpful and necessary considering the behavior of those associated with the site. Today we are very happy to introduce Tim Cantu, who you may know as imsorrydave, who has spent some time this off-season studying the CBA and will be breaking the legal jargon down for us non-lawyer types, henceforth referred to as “dummies.” First up: the Competitive Balance Tax.

Welcome Tim, and follow him on Twitter for more insight on baseball, bourbon, and briefs: @eutimioc2. Also feel free to drop a note in the comments about what legal issues—pertaining to BASEBALL, mind you—you might want Tim to dig into.)

The Luxury Tax is probably the most esoteric legal provision in the CBA commonly appearing in baseball news. It has received more attention than usual this offseason, as teams in danger of paying the tax seek to either avoid it (Cubs, Giants) or dump players with expensive salaries on other teams to get under it (Dodgers). It has informed team decision-making this offseason so much that writers have begun calling it a “soft salary cap.” Let’s talk about what the luxury tax is, what it does, and why teams are acting like this.

I. Tax Thresholds

The Competitive Balance Tax (CBT) is essentially exactly what people named it: a soft salary cap. Rather than forbid teams from exceeding a spending threshold, the CBT penalizes teams that exceed the limit. The CBT threshold is also adjusted year over year, although I couldn’t tell you how they came up with these specific numbers.

A team’s payroll for CBT purposes is comprised of:

1. 1/30th of the costs of player benefits (a specific list of items like worker’s comp premiums, employer portions of social security taxes, Spring Training per diems, All-Star Game expenses, moving expenses, and so on--the CBA provides for all sorts of extra negotiated benefits for MLB players or call-ups, and a team’s CBT payroll includes the 1/30th share of that total across MLB);
2. the actual salaries paid to players on their initial 6-year club contract; and
3. the average annual value (AAV) of the contracts paid to any players signed to multiyear contracts (also known as free agency).

Obviously, the lion’s share of a club’s CBT payroll is actual player salaries, and writers generally use only the actual known salaries to calculate the CBT for teams. The CBA itself does give one tidbit of context: for the 2017 contract year (the season just completed), Club costs for player benefits amounted to $7.3 million per club—and the CBA itself provides that that amount cannot increase by more than 6% per year. So to safely dodge paying the CBT Tax, a team realistically needs a player payroll 7-8 million dollars under the CBT threshold.

II. Tax Mechanics

On December 2nd following each season, Major League Baseball notifies all teams as well as the Players’ Association which clubs owe the tax based on their payroll for the preceding season. The tax is progressive and dependent on (i) how far over the CBT threshold a club is, and (ii) whether they have paid the tax in the immediately preceding year or years.

The tax is only paid on the amount of your payroll over the threshold. Even so, just the base tax rate can be a stringent penalty by the time a club reaches their third year of payment. It only gets worse when the surcharges kick in. There are two levels of payroll at which a team must pay an additional tax on top of the base rate—a 12% surcharge, and a 45% surcharge. That tax is only paid for the portion of payroll by which a club exceeds the surcharge thresholds.

Before jumping to another chart, let’s say the Mariners just go bananas this month and sign Lorenzo Cain, Yu Darvish, and Alex Cobb. We are all thrilled and Jerry Dipoto gets two parades, one before the season starts just for talking ownership into spending money, and one more after they win the World Series and the Angels declare defeat and fold their club. But this pushed Seattle’s payroll to a whopping $221 million! That means they, as a first time CBT payor, have to pay a tax of 20% on the amount by which our payroll exceeds $197 million--that amount is $24 million, so the tax liability is $4.8 million. Not so bad. Also, they have to pay an additional 12% surcharge tax (see below) on the amount by which our payroll exceeds $217 million. That’s 12% on $4 million, or $480,000, for a grand total of $5.28 million in CBT tax. Remember, though, that Seattle’s tax liability would be far higher in years 2 and 3+ of these contracts, as their base tax rate increased.

Here’s one last chart, weaving it all together, and showing the effective tax rate a team pays for exceeding the CBT threshold in every situation.

Once it’s all put together, you see why the Dodgers are desperately seeking to get their payroll under the CBT threshold. Even for a team that essentially prints money, already-bad free agency deals start to look a lot worse when they’re coming at the expense of a nearly 100% surcharge on some of your player salaries. If all this were not enough, there’s one more penalty laid on. For any team that exceeds the Second Surcharge Threshold in any year, their first selection in the following year’s amateur draft is moved back ten places (although if they are picking in the top six, an impressive feat of losing with a $240 million payroll, their second pick gets moved back ten places instead).

Let’s pick back up with my prior pipe dream, uh, I mean, example. In this case, though, the Mariners have to seriously overpay to get their men, and end up with a $243 million payroll. Not only does this increase the tax liability, it places them in the second surcharge bracket. That means for the 2019 draft, the Mariners’ first pick is knocked ten spots back, from 30 (remember, they won the World Series!) to 40.

Or we can go full-on dark timeline: the Mariners spend $243 million to bring home a title, but James Paxton defects to Canada, Jean Segura decides to pursue a career in filmmaking while actually batting in games, and all our pitchers’ heads fall off. The Mariners spiral to a league-worst 11-151 finish and land the first pick in the draft. That pick is protected from the CBT penalty: instead, our second-round selection is moved back ten places, and they pick a promising young catcher with a lot of power from the University of Florida first overall.

III. Tax Spending

So where do these piles of CBT money go? The short answer is back to the players. For each year in which any CBT is paid by any club (and remember, it’s a variable amount—for 2018 it appears as of this writing that there may be no clubs that pay the CBT tax):

(a) The first $13 million is used to help fund MLB player benefit plans;

(b) 50% of the amount of tax exceeding $13 million is used to fund individual player retirement accounts, as specified by separate benefit plan documents which are not public;

(c) The remaining 50% of that amount is split evenly among all clubs that did not pay the CBT tax in that year.

Note: The amount under (c) is not the same as “revenue sharing”, another term commonly used when discussing MLB clubs. That is a separate CBA provision.

You can see that this doesn’t really affect how much money the MLB players get for benefits: the benefit obligations that are receiving CBT money are separately negotiated and paid whether any CBT is paid in that year or not. This is a case of MLB club owners negotiating among themselves: clubs like the Yankees and the Dodgers that want to spend wildly get to do so, but they’re also going to fund more than their fair share of player benefit plans and retirement accounts, and once that piece of the pie is handed out, the other clubs get the rest of their CBT money. Let’s now go to another…

IV. Hypothetical

Here are some real payroll numbers that don’t spring from my feverish OOTP-playing Mariners dreams, applied to the upcoming CBA year. Right now, no team is projected to pay the CBA for the 2018 contract year. I’ll explain my theory on why that is in a minute. But what if the 2015 Dodgers were paying this year’s CBT as a third-time tax payor? Thanks to Magic Johnson et al., that team had the highest payroll of all time, a whopping $271.61 million (plus $7.3 million for player benefit incidentals!). For simplicity’s sake, I’m going to assume that figure includes the AAV of all their free agent contracts.

The 2015 Dodgers paid a significant luxury tax under rules of the previous CBA--I found one report that their total tax bill from 2015 was about $43 million. In this example, they’d pay a massive $62,214,500 luxury tax, driving their payroll far north of $300 million. The 2017 Dodgers, with a far more reasonable $253.6 million CBT payroll, still paid $36.2 million in CBT tax, leading a group of six clubs who paid CBT tax in 2017. By dumping salary on the Braves in the Kemp/Gonzalez Trade, they got under the CBT tax threshold for 2018 and will likely reset their tax calculation in 2019. That’s extremely important to them in this specific offseason for one reason that they share with the Yankees and every other big-money team: the 2019 free agent class.

These teams, the ones with the most cash to burn on a Bryce Harper, Manny Machado, or Clayton Kershaw are those who are already blowing through the CBT threshold annually: the Yankees have paid it fifteen years in a row. To this end, the new CBA introduced surcharge rates as an additional penalty on CBT-paying clubs. Bryce Harper for $35 million in AAV sounds like a pretty nice deal; Bryce Harper for $35 million in AAV plus a 62.5, 75, or 95% CBT tax starting in the third year sounds a lot less attractive. All the more so, then, the clubs that would ordinarily drop $150 million on Yu Darvish or $100 million on Jake Arrieta are extraordinarily reticent to do so, since signing those players now would significantly hamper their ability to take on another big-money deal for a much better player next year.

V. So What About Seattle?

Let’s leave my fake Seattle payroll behind and talk some real payroll numbers here at Safeco. Cot’s pegs the Mariners’ current 2018 payroll obligations--including league minimum salaries and arbitration--at $159.6 million. Last year, their total payroll obligations at year end were about $20 million higher than the preseason number, though that number will vary wildly year to year depending on in-season acquisitions, if they trade anyone away, and so on. Factor in the $7.3 million in player benefit obligations that are calculated for CBT purposes, and you can see where this is headed. If they make any in-season acquisitions, the Mariners are getting much closer than most of us probably suspected to the CBT--indeed, if the Mariners have budgeted to save money for midseason, they’ve likely already planned to spend close to $180 million on the 2018 Mariners.

2019 doesn’t look a whole lot better, even though they drop Nelson Cruz’s current contract. Estimating roughly $30 million in arbitration and league minimum salaries along with existing known salary commitments, the Mariners are already looking at close to $150 million in committed money for 2019 before spending a dime on free agents or trades. The good news: next year’s CBT threshold is all the way up at $206 million. That means next offseason the Mariners will likely drop into the range where they can spend freely without worrying too much about the CBT tax. That’s doubly true in 2020, when Felix and Juan Nicasio’s contracts expire. Using that same $30 million figure to estimate young player contracts, they’re looking at about $113 million in committed money that year, with a CBT threshold of $208 million. They’ll be a lot more liberated from CBT concerns starting then. Yes, folks, Clayton Kershaw will be coming to Seattle.

Tim Cantu is a lawyer in Seattle, but he is not your lawyer. These views are his own, except the Clayton Kershaw thing, which is a joke. He is immensely grateful to Kate and the staff for giving him the opportunity to publish this on Lookout Landing, and plans to honor them by consuming beer in Lookout Landing starting in April.