CBA Talk: Why a Luxury Tax Isn't My Idea of the Answer

The other day, when I threw up another proposal for resolving the NBA lockout, I made mention of people smarter than me. Of those, there are plenty, and one of the guys that fits that description is Tom Liston of Raptors Republic.

On Tuesday, Tom weighed in with three thoughts on the lockout, which you should take the time to read. In fact, I insist you do, because I’m not really going to discuss his entire piece. Instead, I’m going to use poor Tom as something of a straw man to illustrate what I believe to be inherent problems in any luxury tax program. He certainly deserves better, yet here we sit.

In any case, here’s what Tom wrote about an “accelerated” luxury tax:

"I’ll use round figures for simplicity. For example, let’s assume a “standard” cap of $60 million.  If I team is under or that the cap? Zero tax. Spend $60-65 million? Teams are taxed 25% on the incremental amount above $60 million. Spend $65 to 75 million? Teams are taxed at 75% on the incremental amount over $65 million. Spend $75 million and above?  Teams are taxed at 150% on the incremental amount.  Eliminate all the mid-level exemption and other BS. Keep it simple. (Don’t worry, Larry Coon still has a day job). The tiers and rates are obviously up for debate. It’s the type of structure that I think will work."

Now, what he’s saying here is that there are no real restrictions on spending money, provided you are willing to pay extra for it. Though he uses the word “cap,” he’s really creating a “capless” system with a series of thresholds. The previous system is close to “capless,” but the soft cap does represent more meaningful obstacles than this. Under Tom’s system, you only need the willingness and ability to pay. Under the previous system, you need the willingness and ability to pay and either cap space or exceptions or some other mechanism to fit the player into your payroll.

Will It Nick the Knicks?

Consider the following scenario under Tom’s proposal:

The Knicks have about $62 million in committed contracts next year, and we enact the “Liston Plan.” If they chose to, New York could go out and pay “above market” for one of the centers (Chandler,  Marc Gasol, Nene, Dalembert), a defensive wing (Prince, Battier), and — if they were still feeling peckish  — pick up Jamal Crawford for points off the bench. Let’s pretend that, after they’ve filled their roster, they have a $100 million payroll. Tom’s system as described* would charge them about $46 million in taxes, and their total player payroll cost would be about $146 million.

*I do remember the caveat above (that “the tiers and rates are obviously up for debate“). However, it is easier to illustrate with numbers. Further, just as Tom believes those specifics are inconsequential to a luxury tax system working, I believe they are inconsequential to them not working.

No question: $146 million is a huge amount of money. However, it means different things for different teams. If we use Forbes data for revenue (since we have no more accurate numbers), we can at least get a general understanding of what it might mean to the Knicks. We’ll have to go back to 2010 (the most recent Forbes info), but that’s fine. Last year’s payrolls were somewhat abnormal due to teams preparing for both last summer’s bumper crop of free agents and the expiration of the CBA.

According to those numbers, the $146 million would be roughly 68.6% of New York’s revenue. For reference, there were nine teams in 2010 that reportedly paid more than 68.6% of their Forbes revenue in payroll and taxes. Only two of those teams (Boston and Dallas) even had $146 million in revenue. For four of those teams (New Orleans, Charlotte, Indiana, and Milwaukee), this $146 million figure would have represented around 150% of their revenue.

If you’re wondering whether or not New York would be willing to spend like this, look no further than 2006 and 2007.  In those two seasons, James Dolan’s Knicks reportedly had salaries and taxes well in excess of $160 million — for teams that only won 56 of 164 games over two seasons.

Here’s a glance at what the tax would have looked like using 2010 figures:

In effect, such a structure has more freedom, but things get more expensive faster.

Revenue Sharing as Heroin

To further exacerbate the issue, luxury taxes will only be approved by owners if those taxes then go into a pool that supports revenue sharing. In a tax system that is this aggressive, your expectation should be that the luxury tax will be the entire revenue sharing program. In the previous system, that $60 million of revenue sharing that Stern keeps throwing around is the money from the luxury tax. In 2010, each team below the tax threshold received a $3.7 million rebate. This is why teams either stay under or go well over the threshold. If a team had gone $0.2 million over the tax threshold that year, the actual penalty would have been $3.9 million — $0.2 million in tax plus $3.7 million in lost revenue sharing.

Now, it was easy in the previous system to see how the revenue from the tax would be shared, because you had a binary state. However, under the Liston proposal, the owners would have to create a more nuanced revenue sharing formula. The simplest way to do this is to flip the 0-25%-75%-150% pay schedule. Teams under $60 million would receive four shares, those under $65 million would receive three shares, those under $75 million get one share, and any team over $75 million would receive nothing.

If we look at that 2010 payrolls, what would that do?

It would have had the majority of teams (25 of them) paying some tax. However, the majority would also be getting something back. In fact, 18 teams would be net recipients (and a quick look at 2011 shows it would have been 15).

Arguably, it does a decent job of revenue sharing, but what does it really do to the individual teams?

Under the previous program, there were a number of teams that treated the tax threshold as a de facto hard cap — or at least considered it a restraint that would severely limit when and by how much they would spend above the luxury-tax limit. Meanwhile, the dollars involved were largely meaningless for teams like New York and the Lakers (and possibly Chicago, though Bulls owner Jerry Reinsdorf is pretty frugal).

And this will always be the case with any luxury tax. The stronger you make it, the bigger the advantage you give big dollar teams. This happens in two ways.

First, let’s use the smiley face 1-to-10 pain scale you see at the doctor’s office to roughly illustrate how teams view the tax. You have teams like the Knicks and the Lakers down between 0-2 right now. The Bulls might be at 2-4, and a couple of other teams at around 6. But most will be clustered up in the 8-10 range. They either are not willing to cross it at all, or they will only do so in extreme examples.

The goal of raising — or more accurately in the Liston proposal, changing — the tax is to move the high-revenue teams up on the scale towards six or higher. But in doing so, you start pushing more and more teams off the scale entirely —  effectively imposing hard caps on the teams that already struggle to compete with big-pocket teams.

Second factor is the revenue-sharing aspect.

Under Tom’s formula, plus my revenue-distribution plan, a “share” would have been worth $5.4 million in 2010. In other words, crossing over the $60 million threshold in 2010 would cost a team $5.4 million. Crossing over the $65 million threshold would have theoretically cost $10.8 million. And crossing the $75 million threshold would cost another $16.2 million. (This all is excluding the impact of additional payroll and taxes.)

As a stark example, Sacramento had payroll of $63.0 million in 2010 while Atlanta’s was $65.1 million (both according to Shamsports). Under this proposal as structured, after paying in their taxes, but getting back their shares of revenue, Sacramento’s net payroll expenditure would have been $47.7 million while Atlanta’s would have been $60.1 million. Of course, this can be tweaked by changing the percentages, but it always holds true — it’s just a matter of scale.

Ultimately, a luxury tax is neither a tool for competitive balance, nor a particularly sensible way to share revenue. What a luxury tax does is effectively create a market where teams can buy and sell (theoretical) competitive advantage. And teams spend to keep players and stay good or add players to get better (Isiah Thomas notwithstanding). It’s a coin that always has two sides. The harder you make it to go over, the sweeter you make it to stay under. That kind of market favors deep pockets, and encourages poor teams to take the money and run.

If I were a small-market owner interested in being able to compete without having to sell a kidney, it’s extremely unlikely I would ever vote for any system that includes a luxury tax. The Bucks, Bobcats, Hornets, Spurs, Thunder, and of course your Pacers could spend $80-$85 million (in 2011 dollars) in their markets and maybe break even or squeeze out a meager profit. But they would gut themselves financially trying to spend the $112 million the Lakers spent in 2010 or the $102 million the Mavs spent in 2011. If I was a “poor” owner, I would prefer the previous system — as a whole — minus the luxury tax to any system that makes the luxury tax more aggressive.

Speaking of the Mavs, I’ll be so presumptuous as to say Mark Cuban would be nodding his head if he was reading this.The luxury tax of the previous CBA was pretty high on the pain scale for Dallas — a good-to-very-good revenue market — but Cuban had been willing to gut it out. If, as speculated, the Dallas owner is a hawk in favor of a hard cap, it’s because he doesn’t want to lose another $150-$200 million over the next decade trying to keep up with his rivals in New York and LA that can spend even more and still make money.

There are a million different ways to try to calibrate the system so that this, that, or the other effect isn’t so pronounced. However, at that point, you have abandoned the principle of simplicity. Besides, this is what luxury taxes do. They make things more expensive, and that will disproportionately affect the “have nots” more than the “haves.” Worse, the revenue-sharing aspect will further encourage teams not to spend.

No matter how many modifications you make to a hammer, it’s never going to be a scalpel.

The Complicated Nature of Flexibility

But, in a vague effort to be fair to Tom, most of that is a side effect to want he wants. Mr. Liston preferred a structure like this for its flexibility.

"A hard cap takes away flexibility. We have already witnessed too many “filler” players in trades just to make salaries work under the current system. Do we really want to make it worse?!"

Look, I love the idea of not having to match salaries in trades, which is why I blatantly stole it from Jared and put it in my proposal the other day. Here were Tom’s thoughts on the concept.

"Part II of the idea. Salaries on trade do not have to be within 125% of each other (the rule for salary coming in for teams above the cap).  However, a minimum “floor” of salaries has to exist.  How about teams cannot go below some number like $48 million?  Teams have a small grace period (48 hours) to get back to that level after a lopsided trade.  However, effectively they would have to close two separate deals simultaneously or risk having to do a bad deal to take back salary again.  Keep it simple and allow for more flexibility in trades with less “fillers”.  Combined with idea #2, it should allow for trade flexibility, which all parties should want."

The difference between his proposal and mine is that, in his, you have to match salaries only in trades that threaten to put teams below the floor. In mine, you have to do it only in trades that threaten to put teams above my hard cap. However, in this system, he’s right to be concerned about teams being around the floor. This is also where we start to see some practical problems.

Some owners will push for a lower or no floor, because the proposal, as it stands, will create the NBA versions of the Pittsburgh Pirates and Kansas City Royals. Truth be told, that may not be the worst thing in the world from a business perspective. It offends our sensibilities from an always-play-hard/come-home-with-your-shield-or-on-it point of view, but it can’t be ruled out as a possibly sensible financial approach to the league.

The biggest practical issue is that I have no idea how it would work in concert with a 53% guarantee. The MLB has no guarantee, no cap, and no floor — just a luxury-tax threshold. Teams can adjust to their markets, and as a result, MLB players in a capless market get only about 44% of revenue and only six teams paid more than 50% of their revenue in players salaries in 2010.

In fact, it is these figures that might make most owners argue against the floor, and possibly towards offering a “capless” system like this, but giving no guarantee. The players might bet that this would result in their split of the money rising — which is the common perception of what would happen in a “free” (or almost free) market, but the owners could bet otherwise.

The owners could see a scenario in which there is a short-term bump in players’ salaries and BRI split, but it would not sustain itself. As the league moves forward, the market rationalizes itself.  More importantly, the owners have now detached the players from the revenue, and thus, possibly, the growth of the league.

The MLB is a completely different beast from the NBA, but it’s not out of the realm of possibility that, in this “capless” society, the players could come out huge losers. The shackles that tie them to soft caps and mid-level exceptions and “Bird rights” also tie them to the next national television contract. It would crush some teams competitively, but it could conceivably stabilize owner value and cash flow for all — and enhance both for some.

Remember how the owners claimed victory in the last lockout and now regret it?

This is one way the players could possibly live that same experience.

However, that contains a good deal of risk. There’s no guarantee that if the system lets teams adjust to their market — as has happened in Major League Baseball — that all markets would be sustainable. It could result in relocation or contraction. Of course, that is a seemingly omnipresent risk for some teams today already.

Tom’s idea would work relatively well in a league where all of the teams had revenue streams within a relatively narrow band of each other in any given year. One where all teams have a realistic shot of at least semi-regularly having years that would be above the mean in revenue. That, however, is most certainly not the case in the NBA, a league that has some teams bringing in more than $200 million annually and others who can’t even make $100 million.

I just don’t think it will work in when the distribution of revenue looks like the chart below.

Big-dollar owners (should) love the idea of a luxury tax, because it creates a market in which their money advantages are amplified. Small-market owners (should) hate a luxury tax, because it’s basically putting them on the dole and making them into forgotten men.

If they want to compete or keep a young, talented team like Oklahoma City together, they will have to spend with the big boys. And not only would they have to forgo any support from revenue sharing, but they’d have to pay for the honor.

They would be taking a knife to a gun fight.

(Note: A few sentences of this post were edited after initial publication for clarity.)