Major League Baseball has a luxury tax, called the “competitive balance tax”, in place of a salary cap in order to level the spending an individual team can spend on their roster. If a league lacks a salary cap or a luxury tax, any rich team can spend all the money they can afford on players. This means teams with smaller pockets cannot keep up with the richer teams, as they cannot afford the top talent, giving them a competitive disadvantage against the rich teams.This disadvantage calls for some sort of limitation on spending to make it a lot harder for the richer, bigger market teams, in order to spread the competitiveness across the league. In other professional sports leagues, there is usually a salary cap on what each team can spend on their players and they cannot go over that level. Major League Baseball decided to install a luxury tax instead to keep the competitive balance in the league. This means that at the beginning of each year, a threshold is set by the Commissioner's Office of Major League Baseball to how much a team can spend on their players. In Major League Baseball, their “competitive balance tax” allows teams to go over the threshold, but at a premium. The goal of this is to encourage big spending, but to still maintain a great balance in competition. Major League Baseball implemented the “competitive balance tax” in 1997, and it has undergone several changes since the beginning.
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Proof a tax works
In professional sports, there is a want for a competitive balance from the commissioner's office, as they do not want the same teams to win every year, largely because of concern that failing teams will go bankrupt, making the league’s market smaller. A study in the Academy of Business Journal back in 2013 shows a relationship between all 30 MLB teams’ winning percentage, team salaries, operating income, operating profit margin, gross profit and team revenue from 2002-2010. This study purports to have proven that there is no difference in profit when there is a payroll increase, but there is a significant increase in winning percentage with an increase in payroll, so therefore teams can spend as they have to help their teams win, and general managers will prioritize wins over profits, allowing teams with more favorable revenue situations to spend more, leading to imbalance.
Major League Baseball uses a luxury tax to increase the competitive balance, and doing so is justified by a working paper from the University of Zurich. It develops a game-theoretic model that addresses the effects of a luxury tax on competitive balance, team profits, and social welfare. This model has half the teams above a certain tax threshold, and the other half below. The teams above would pay taxable balance from their excess amount, and it would be redistributed to the teams below. This research proved that the small teams could have a larger salary than before, and the larger teams would not be affected as much. In other words, the total salaries of the league increased, helping the players, and the competitive balance and social welfare grew, helping the fans. A luxury tax can reduce competitive imbalance, help out low end teams compete, and evidently create a better league for the fans, at the expense of richer teams that can afford it. This led to Major League Baseball to implement their own luxury tax system.
1997-1999
In 1994, the Major League Baseball season was cut short due to the Major League Baseball strike, caused by a massive rift between the players and the owners. One of the major problems was the amount of power owners have on spending on their players. The small market teams felt handcuffed by the amount of money that they could not spend, and the players did not want to get paid less due to a traditional salary cap. This resulted in a compromise of the Major League Baseball's first luxury tax in the Collective Bargaining Agreement of 1996.
The first agreement agreed that the top 5 salary teams in each year would pay a 34% fine on each dollar a team spent halfway between the salaries of the 5th and 6th team. For example, if the 5th highest salary team had a payroll of $100 million and the 6th highest salary team had a payroll of $98 million, the top 5 teams would pay 34% on each dollar they spent over $99 million. Here is the amount of money each team paid from 1997 to 1999, when this system was in place.
2002-Present
The system today is based on the change in the collective bargaining agreement of 2002. After the luxury tax was gone from 2000-2002, the MLB brought it back with a new change to the system. Instead of putting a level between the 5th and 6th team, they decided to set a threshold that a team could not pass without a fee. This allowed teams to control their own fate more, as they were not being compared to other teams. This meant they would get punished only if they passed a certain level, rather than if they were in the top 5 in the year for salary. The 2002 CBA set the threshold for the 2003-2006 seasons, was updated for the 2007-2012 seasons in the 2006 CBA, and was updated again for the 2013-2016 seasons in the 2012 CBA. The 2016 CBA has set the threshold for the 2017-2019 seasons. The tax threshold for the 2003-2019 seasons are in the table below.
Just like the old system, teams would have to pay a percentage of every dollar that their payroll passed this threshold. Under the 2002 and 2006 CBAs, the agreement brought about a progressive taxation system. They agreed that first time offenders would pay a fee of 17.5% on the dollar (later increased to 22.5%), second time offenders would pay a 30% on the dollar, and third time offenders would have to pay 40% on the dollar. In the 2012 CBA, after seeing teams go over more than three times, the agreement added a 50% taxation level when teams went over the limit four or more times.
From 2003-2016, there has been at least one team to surpass the tax threshold, however only seven different teams have passed the threshold. Here is a breakdown on how much each team has paid since the inception of the new competitive balance tax in 2003.
Allocation of Taxes Paid
On December 2 at the end of each contract year, the Commissioner's Office notifies every team that went over the tax threshold that they must pay their tax by January 21 of the following calendar year. The Commissioner's Office then redistributes this money in a standard manner. The first $2,375,400 goes to fund the players as described in the MLB Players Benefits Plan Agreements. Of the remaining sum, 50% will also benefit the players, but it will be put in a long term plan and accrue interest. Of the remaining 50%, 25% will go into the Industry Growth Fund to help the growth of baseball worldwide, and accrue interest, and 25% will be used to defray Club's funding obligations from the MLB Players Benefits Agreements.
Other MLB Revenue Sharing Policies
Major League Baseball also has policies improving the competitive balance off of the field. As a part of their base plan of revenue sharing, each team sends in 31% of their local net revenues into a putative pool. Local net revenues is described as gross revenue from ticket sales, concessions, etc. minus central revenue from television and radio deals minus actual stadium expenses. This pool will then be distributed equally to all 30 teams, regardless of how much you paid. If you paid more than you were distributed, you were labeled as a payor, but if you were paid more than you contributed, you were labeled as a payee. This system is a direct way for poorer teams to get more money from the richer teams, an effective way to level the competitive balance.
Reaction Across the League
The effectiveness of this tax is still uncertain among MLB owners, as they take different approaches to the situation. Due to increasing tax levels the more you pass it, there is always an incentive to not surpass the level in successive years, as the penalty gets larger. That increasing incremental penalty can affect a team's decision regarding whether to retain a key player when they are already over the threshold, as they may be averse to paying a larger, substantial fee. Some owners have stated that they will spend whatever they want as long as it is beneficial to the team, whereas others admit that it can handicap the team a lot in the long run.
Effectiveness
The effectiveness can be viewed in two different ways. As the years have gone on, the tax payments only increased into substantial amounts. According to USA Today Sports, more and more teams have come close or surpassed the tax threshold in the recent years, as salaries have inflated especially in the past few offseasons, despite owners wanting to stay below the tax threshold. Despite “the big spenders trying to spend less,” they are not trying hard enough. This is shown as certain media outlets believe that the luxury tax is not changing the mindset of owners truly. However, in 2015, it was teams in the middle of the payroll pack winning playoff games, as well as the World Series, as none of the teams that went over the tax threshold won a playoff game. This is a lot different from the Atlanta Braves and New York Yankees dynasties in the 1990s. Despite the success in 2015, the effectiveness could be an outlier. According to fivethirtyeight’s Noah Davis and Michael Lopez, despite of the new system, cash buys more wins now than they did in the past. They also state that it is a case by case basis, as some teams win less when they spend more, proving there is no true answer to the effectiveness of the tax.