How is the Luxury Tax Determined in MLB?

How many times have you heard the words “salary” and “cap” together when following professional sports in the United States of America? For the common fan we hear “salary cap” quite often and just about as often don’t pay attention or simply don’t understand. Let’s be honest, it’s not the most exciting topic in sports, but may be one of the most meaningful. The definition is actually very simple – put plainly it’s a rule (or agreement) that limits the amount of money a team can spend on player salaries. It can be determined in one of two ways – limits on per player salaries or total team salary depending on the league. In US professional sports almost every league, including the National Football League and National Hockey League, has some form of salary cap in place (the NBA has a soft cap, which differs from a true salary cap), except Major League Baseball. Instead of a salary cap, MLB has a luxury tax and has operated this way since 1997.

What is the Luxury Tax?

The Major League Baseball Competitive Balance Tax is more commonly known as the “luxury tax”. Each year, the league sets a financial threshold for a team’s respective payroll. The teams who carry payrolls above this threshold are subject to a tax on each dollar that is over this predetermined target. The team’s Competitive Balance Tax is determined by the average annual value of each players contract on the 40-man roster, plus any additional player benefits. At present, the luxury tax is in place until after the 2021 season via the Collective Bargaining Agreement from 2017. One of he most dangerous aspects of the luxury tax is it increases each year a team is consecutively over the threshold. First time offenders will be penalized 20%, the second year increases to 30% and if a team is exceeding the limit for three consecutive seasons they will pay a 50% tax on every dollar over the threshold. This resets when a club goes back under the threshold for a full season. To make matters worse for the big spending clubs if they are $20-$40 million over the limit they will also be popped with a 12% surtax. The best part about the luxury tax is that when collected it’s mostly redistributed back into the league….to the compliant teams!

Now that we know the tax rate, what’s the threshold each team is looking at? Between the years of 2014-2016 the total amount was $189 million. It has steadily risen over the past few years:

  • 2017 – $195 million
  • 2018 – $197 million
  • 2019 – $206 million
  • 2020 – $208 million
  • and in 2021 it will be $210 million.

Now that you know the tax rate and the threshold, let’s take a look at the offenders.

The Luxury Tax Offenders

In 2019, there were three teams above the luxury tax – the Boston Red Sox, Chicago Cubs and New York Yankees. Keeping in mind the threshold was $206 million (see above), the Sox Opening Day payroll (calculated by the rules of the Competitive Balance Tax) was $248 million, the Cubs clocked in at $225 million and the Yankees were right behind at $223 million. The Washington Nationals were 4th and under the threshold at $198 million and for those of you keeping score at home Pittsburgh Pirates and Miami Marlins were last by a country mile at $83 and $81 million. The Cubs and Yankees were first year offenders (not first year ever, but in terms of consecutive years) and the Red Sox were on their second consecutive year over the threshold. In 2018, the Red Sox paid close to $12 million for being over and in 2018 and figured to pay a similar amount last year. The Cubs were hit with an $8.5 million bill while the Yankees tab was around $6.5 million. No surprise the Red Sox cleaned house this offseason!

The 2020 Outlook

Heading in the 2020 MLB season it looks like the Yankees are going to be a second year offender of going over the luxury tax threshold. Thanks to the Red Sox it looks like they’ll have company in the form of the Mookie Betts lead Los Angeles Dodgers. Both the Cubs and Red Sox cut their projected opening day payrolls under $190 million, which will reset their luxury tax consecutive year liability. The Yankees are fixing to be in some big trouble for years to come with Gerrit Cole and Giancarlo Stanton’s monster contracts. Not to mention the fact they are going to have to pay for Gleyber Torres, Aaron Judge and Luis Severino at some point as well. Once again the Pirates and Marlins are projected to be at the bottom of the league only this year they will be joined by the Baltimore Orioles as well.

Does the Competitive Balance Tax work? Is the playing field leveled for the large market teams vs. the smaller market teams? Every baseball fan knows the answer to that question. At the end of the day a $10 million luxury tax bill is a speeding ticket for a large market team. Especially a large market team that makes it to the World Series and potentially wins. For example, the signing of Gerrit Cole by the New York Yankees will probably generate enough merchandise revenue to cover their luxury tax bill. Ultimately, the big market teams still have an advantage in Major League Baseball, which is why we can never understate the job guys like Billy Beane do in Oakland. The whole “Moneyball” narrative is often a joke, but the fact of the matter is it’s a playbook for a small market team to compete with the giants. In 2020, the New York Yankees will pay players an estimated $240 million in total salaries. The Oakland Athletics, who have a strong shot at making the playoffs….$85 million. The numbers are dramatically different and the Yankees, who will be paying the league an extra $15 million (approximately), don’t seem to mind it one bit.

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