This is part four of a six-part series exploring spending optimization in Major League Baseball. Each article will dive deep into different ways that teams spend their dollars to produce the best value. You can find part one (and the rest of the series) here.
Referred to as a softer version of a salary cap, the Competitive Balance Tax (also known as the Luxury Tax) has major implications in affecting team spending strategy. The same player can cost two different amounts, depending on prior spending.
Therefore, we can consider all types of spending, in this regard, as dependent on one another. Before these effects and the relationship of that dependency are elaborated upon, it is necessary to clarify the interworkings of this measure.
Establishing the Basis of the Tax
The Competitive Balance Tax, as defined by Major League Baseball, is a penalty (or tax) given to certain teams that spend above an agreed-upon threshold for that season. Any money or benefits given to players on the 40-man roster on an average-annual value basis could be subject to the tax.
With a relatively new Collective Bargaining Agreement signed, the following are the new thresholds for the tax:
If a team crosses the threshold for a year for the first time, it is subject to a 20% tax on all overages. If the team does it for the second time in consecutive seasons, it is subject to a 30% tax on the overages. If the team disregards the tax and decides to continue spending above the threshold for three years or more in a row, it is subject to a 50% tax on the overages. These penalties restart if a team goes below the Competitive Balance marks for a year.
In wanting to ensure compliance with these rules, there are additional disincentives to exceeding the luxury tax by given amounts. A ballclub that spends $20-40 million above the threshold is subject to an additional 12% surcharge on overages, $40-60 million is faced with a 42.5% and 45% surcharge (42.5% for the first season and 45% for any consecutive following seasons), and $60 million or above is bestowed a 60% surcharge.
Teams can also have their draft picks moved back 10 spots (unless in the Top 6, then back 10 spots for the next highest draft pick they own) for exceeding the tax by more than $40 million, which can be crucial in long-term decision-making.
These rules combine to attempt to ease Major League Baseball’s spending disparities – whether it does or not is beyond the scope of this. Either way, investigating the possibility of exploitation could be crucial in how teams spend on their rosters.
It is important to note that these luxury taxation rules only apply to the current collective bargaining agreement, and may be changed in the near future. If changed, the applications that will be elaborated upon may have less standing or effect in what is possible.
Likely, any change soon would only warrant a slight adjustment. But, if a salary cap does eventually replace the luxury tax, this research would be null and void. Luckily, teams have at least a few years left to possibly take advantage.
Mixing the Competitive Balance Tax and Spending Optimization
There is perhaps a reason that most people generally dislike intricacies within rules – it is so much easier to find exploitability and partially get around them. With the current structure bending to so many different scenarios, teams could navigate around the luxury tax rules to create an advantage for themselves.
This is where the Spending Optimization aspect of Major League Baseball comes into play – how could teams successfully allocate their spending to take advantage of the Luxury Tax? This section specifically applies to bigger market teams, as most small or middle-market franchises have no concerns about possibly being taxed.
In looking at big-market franchises, the correct optimization of spending in certain spots or years could save them millions of dollars of wasted value.
When having to subject certain spending to the Competitive Balance Tax, it is like having to pay a premium for every single win. If Team X signs a hitter for $20M for 2023 when their CBT payroll was already at $230 million (threshold at $233 million), the real cost of that player is $23.4M for a first-year offender.
That $3.4 million premium (20% on a $17 million dollar overage) may seem small in comparison to a large payroll, but these wasteful amounts can quickly add up under the structure. Just an additional $3M on top of that signing would’ve subjected that team to a surcharge, which would have led to additional wasted dollars for future years. These wasted dollars can lead to fewer wins over time, which is obviously detrimental.
As efficiency is one of the key aspects of the proposed Spending Optimization in baseball, targeting and limiting expenditures on the Competitive Balance Tax could prove beneficial in near-term and long-term success. Premiums, like the tax, should try to be avoided at all costs.
With successful optimized payroll plans and designating certain signings to given times, these high-payroll teams could save themselves massive amounts of money and draft pick falls, leading to more future wins.
Navigating Transactions to Avoid Repeated Overages
As was made clear in the clarification of the competitive balance tax, teams are penalized at higher rates when they continuously surpass the tax thresholds. The base tax experience adds 10% after the second year of surpassing the threshold and then adds 20% in the following years (for a total of 50%). The surcharge tax also experiences a bit of a raise after consecutive years of passing the given threshold, with the 40-60 million moving to 45% from 42.5%.
Hence, it is easy to establish that avoiding repeated overages could be beneficial. As mentioned earlier, the Luxury Tax is calculated using average annual values (AAVs), not cash disbursements for a given year. Therefore, a team cannot defer and adjust different cash amounts counting towards the luxury tax, but could only lengthen the contract in itself. So, a team needs to consider multiple aspects when deciding whether to sign a given contract.
To be truly successful at this, a team needs to know their preferences and their confidence in projections to truthfully make the right decision. In building off Part Two of this series, it was clarified teams will generally have a preference for minimizing SNE, or Non-Effective Spending. To understand more about the specifics of SNE, read here.
For now, it’s worth highlighting the fact that every aspect of SNE can be related to the size of a contractual commitment. With Injured List spending, it is a well-known health science fact that older players lose muscle mass and flexibility causing injury, which long-term deals subject a given player to that risk due to the length of a deal.
In retained spending, signing a given player for too long leads to a given team covering the funds of released, bought-out, and traded players. Buried Spending is somewhat similar to retained spending – players who are signed beyond their worth to a Major League roster are put in the minor leagues.
Ergo, it is safe to assume that teams would prefer to pay a premium for short-term deals compared to a potential risk of a long-term deal (organizations generally value certainty as well), isolated from the Luxury Tax. The equilibrium before the tax would look like this:
If CL(S) > CL(L),
CL(S) * AP = CL(L)
CL stands for Contract Length, S for Short-Term, AP for AAV Premium, and L for Long-Term.
In this equation, CL stands for Contract Length, S for Short-Term, AP for AAV Premium, and L for Long-Term. Again assuming for the preference of short-term deals over long ones, a given premium could even out the intrinsic value to a given team. As previously stated, this is before the Luxury Tax.
In the isolated view of the Luxury Tax, the preference changes – Long-Term Contracts are preferred to Short-Term Contracts. This is due to the fact that a higher AAV amount is more likely to cause a tax overage, which will immediately subject the team to penalties. In a proper equation, this needs to be accounted for in detail.
Again, the equation needs to thoroughly consider what the lost market savings might be from not signing the player to more years and the premium of paying a higher AAV for fewer years with the team condition in mind. On the other end of long-term deals, it needs to consider the probability of non-effective spending happening due to the length of the deal. After going over those aspects, one is at the luxury tax transaction structure equilibrium (LTTSE for short).
If CL(S) > CL(L),
LTTSE = (CL(S) * AP * TC) – (CL(L) * SNE)
TC stands for Projected CBT Cost, SNE stands for Projected Non-Effective Spending
Treating both numbers as positives, if the LTTSE is negative, then a team should not go forward with the deal, and exclude it from their portfolio. A projected CBT cost that is above the team-adjusted market savings would imply extra unnecessary money being spent, which should be avoided. If the LTTSE is positive, then a team should go for the deal, adding the deal to their portfolio. Paying a premium in luxury tax is justified if one can save more in both the actual cost and projected SNE cost.
The formula in itself is not very complicated – the calculation of the projections is another story entirely. Teams should try to appraise these values with as much confidence as possible, although it cannot be precise due to the nature of such work. If the approximations are accurate enough, then teams should be able to successfully consider the luxury tax implications of long-term deals with the equilibrium.
Adjusting Player Compensation to Reflect Tax
When a mega-payroll team signs a great and expensive player to a team, the media will be quick to report the deal with the exact figures and commitments. What they do not report is the associated outside costs of such a deal, including the Luxury tax.
One would imagine that this is a consideration in all types of Major League deals by teams, but there is no way to be certain. Even the brightest of them all sometimes conveniently ignore unpleasant aspects of an intended happy instance. With that in mind, the emphasis on adjusting these contracts in portfolio consideration needs to be examined.
To begin, the consideration of any type of contract evaluation should include the extra guaranteed expenses, as well as the probability portion of incurring any extra expenses that could be stipulated from the actual deal or external league forces. Specifically applying this to the competitive balance tax, the incurring of such an expense is not always a guarantee.
However, by considering the probability of contract negotiations and signings, a team can more accurately gauge their likely commitment. Knowing the full extent of commitment allows for more educated offers, and even the possibility of adding a selling point to a player – this is not just a team-related endeavor.
In theory, any offer that a team makes to a player should equal the amount they want to pay in total or the luxury tax expense, contract expense summed up, and lost roster space for a replacement-type player. This means that big-market squads are at a disadvantage, as their all-expenses included bid would look equal to that of a small-market club but would be more expensive in actuality.
Acting rationally, large-market teams would decrease their bid size as the market allows with hopes of fitting both their spending goals and acquiring the needed players. As stated many times throughout this entire series, the amount of dollars a team spends does generally contribute to their wins. The team that is spending a lot can likely afford to lower their offer as players are generally willing to forego a fraction of their paycheck to have the possibility of winning a championship. This relationship will be examined.
Any given offer in evaluation needs to include the other factors. In a mock offer relating to the luxury tax, the intrinsic value of the winning factor to the player needs to be considered from the team’s perspective in an offer to the player. (which will be assumed to be interchangeable to a realistic extent). The offer evaluation would look something like this for both sides (through the lens of the CBT):
Actual Cost of Offer for Team
(Cash Offer – League Minimum Salary + Luxury Tax ) + Roster Space
Actual Benefit of Offer to Player
Intrinsic Value of Extra Spending through Winning + Cash Offer
This is admittedly a simplified version of the values being exchanged (there are additional factors for both parties), but this serves as a great example of the important points trying to be made without muddying the waters around. Having those offer evaluations in mind, in theory, teams could leverage their prior spending to provide real value in future offers, creating a sort of effect to negate some of the potential luxury tax fees.
In truth, the ability to maximize such consideration of offers is probably limited. A team could potentially appeal to a player’s inner desire to win through these evaluation structures and possibly get a deal for cheaper than the rest of the market, but that is far from guaranteed.
The important thing to remember is that a team should always know their position in what they are offering versus what the player is getting, which is far from transparent. This framework hopefully brings some transparency in considering the luxury tax’s role in these negotiation elements – how it is ultimately applied can be up to a given team.
The Path Around Heavy Spending
Repeatedly going over the tax does hurt, but going over it by large marginal amounts can be just as bad. While the amounts have changed from one CBA to the other, deep percentage taxes and other penalties take hefty amounts from those teams willing to spend above all of the others.
The current surcharges were mentioned above in the opening paragraph, but here is a reminder:
These are not small tax amounts; consistent dollars subjected to such a fee will build up a vast volume of wasted spending, which is terrible for the economic and competitive outlook of a team. Hence, the idea that avoiding these heavy surcharges should be a priority for a team should not be that outlandish to the reader.
While these spending amounts and other aspects of the competitive balance tax weave a complicated web, it is possible to cut through the silk – teams can behave differently and be subject to fewer surcharges. The degree of that will vary on the team and their willingness to be either crafty or differentiate their actions, but it is entirely possible.
These couple of strategies showcase that.
Leaning on Deferred Contracts
Fans continuously love to hate and belittle teams that take on extended deferred contracts, citing the conventional logic that paying players who aren’t even playing anymore is illogical.
They do not have the full story. When a team decides to defer a given amount to a player, they are getting three clear benefits: increased payroll flexibility, a lowered AAV, and net present value costs. These ideas are already well established in the baseball community, although I will state them for clarity.
Teams get increased payroll flexibility by not having to count current dollars against the current luxury tax. They get a lowered AAV, which as previously mentioned, counts less towards the Luxury Tax. They also have net present value costs by getting to pay the same nominal amounts against an inflation-adjusted tax, meaning that both the payment and the tax bill will be relatively less in the long run. These are obvious benefits, but some additional factors also need to be taken into account to properly adjust a portfolio.
While deferred money does cost less in the form of a tax bill, teams are generally inclined to pay a set rate of interest on the funds, negating some of the savings. But, interest is only one portion. To be successful, a team must have higher projected savings on the Luxury Tax than the cost of the interest and projected future tax costs. Holding all spending rates equal, it will naturally happen.
But, spending rates are rarely constant for teams. If a team anticipates major spending shortly, say… due to an upcoming re-negotiated TV deal and an owner hungering for a star player, then projected future tax costs will jump as the rates are highly progressive. The sum of the interest and future tax costs would exceed that of the current savings, making the deferred tactic worthless in the long term.
If the team can properly project and adjust for such situations, then they will be able to act accordingly. The deferred spending taxing can be extremely beneficial in the right environments, but teams must be fully aware of that environment. Otherwise, ignorance could lead to misplaced action.
Assuming a team has a regular and rational long-term outlook, then adhering to such advice for deferred payment decision-making will serve them well in saving them wasted dollars and having an optimized portfolio.
Switching to Incentives to Hedge
Here is a hypothetical: Player A offers a team two deals. The first deal is a guaranteed $40 million over 4 years. The second deal is a guaranteed $10 million with $75 million in max incentives with a 40% expected payoff rate over 4 years.
Now, both deals have values that technically equate to $40 million over 4 years – which one should be chosen? The answer is the second deal, and here is why.
In general, the goal of incentives is to create a win-win proposition for both teams and players. The player gets paid more to add more value to the team. On the flip side, the player gets less if he does not add the value that could’ve helped the team. If one accepts the first offer, none of that matters. A team will not be better or worse, gain or lose, regardless of the outcome. They would still be on the hook for the $40 million and the resulting luxury tax fee.
If one accepts the second offer, it all matters. If the player had some great years required of him, then the team likely did better, gaining revenue while incurring the cost of the incentives and extra tax. If the player did not perform as well over those seasons, then the team likely did worse, losing revenue while saving money from not spending on the incentives and taxes. Deal 2 successfully implements a hedge.
Hedging is a very common practice in the financial sector and life itself, where risk levels are lessened by allowing for multiple outcomes to occur and not causing extreme loss or extreme gain. In the example, the second offer requires more money and more taxes if they win, but the corresponding outcome makes it acceptable. A team should be willing to accept a higher burden if they know the resulting revenue will at least cover and then some.
On that same note, a team should not want to be stuck with a large bill and tax if they lose, as that will only allow them to not recover in the future. By hedging the potential bill as well as future and current luxury tax obligations, teams will have much less risk to their portfolios in making moves to win.
Concluding Thoughts
Ultimately adjusting for the Luxury Tax is a needed ability for any big-market team, but the number of teams that need to adjust is abysmal. In a look at 270 team seasons between 2012 – 2021 (excluding 2020), only 27 went over the threshold for the given year (10% of the sample). This fact is not opened to undersell the importance of such a factor, but only to bring reality to it.
Many teams do not even have to remotely worry about implementing such strategies into their organization, making this aspect of Spending Optimization somewhat useless to them. Nevertheless, big market teams are stuck paying $100s of millions in these expenses, making the application of such theory quite useful. The advice all across the consideration of portfolio theory in baseball for any part is far from a uniform standard for any team, and it should be applied in such a way.
The Competitive Balance Tax may serve as a bane to teams, but it can be navigated. With the current structure, repeated overages from long commitments have shown to be very costly. In some cases, it may be worth paying a higher average annual value in hopes of not being continuously stuck with an ineffective obligation. This can be addressed through the LTTSE (luxury tax transaction structure equilibrium), which tackles the worthiness of such long-term deals and attempts to categorize whether the luxury tax implications of one make it worthy or not.
Considering the actual costs and benefits involved in luxury-tax-related transactions has also proven to be crucial in managing a team’s portfolio. Teams and players are paying two different prices – the key is knowing both prices and considering the balance between the two. When a team can acknowledge these differences and factor them into offers, signings can be made that avoid potential pitfalls. Heavy spending has also proven to be extremely harmful, making the avoidance of such deep overages necessary.
By opting to utilize deferred contracts (in the right scenarios) and hedging via incentives, teams can potentially limit their temporary income and loss. This allows for a better competitive balance tax bill, lifting the burden. As the Luxury Tax continues to be expanded upon in the coming years, these thoughts show a few ways in which heavy-payroll teams suffer a bit less.
Some of these teams may appear as if they do not need to worry about money, but in truth, they always do. Every dollar, no matter the size of the team, truly does count. An avoidable dollar spent on the luxury tax could’ve gone towards data or scouting efforts within the front office. Examining the competitive balance tax, and spending optimization in general aims to convert those avoidable dollars into effective dollars … to preach efficiency.
As genius as the baseball world is, it is not completely efficient. Avoidable spending is still happening is still happening – the reasoning behind that is beyond the scope of this look. But as long as teams are willing to accept that they do need to evolve and consider that optimizing certain things may assist the team in winning, then the future is in bright hands.