The trade deadline won’t come for another couple of months, but now seems like as good a time as any to discuss the luxury tax and how it might impact the Phillies ability to make transactions this season. The Phillies have a very high payroll and many writers and reporters have speculated that anything more than a moderately-priced addition could push the team over the luxury tax threshold.
With that in mind, I decided to read the appropriate section of the Collective Bargaining Agreement to get a stronger grasp on the tax and its implications. My goal is to provide an overview so we can determine, almost instantly, what would need to happen for a certain trade to go through if the Phillies want to avoid getting hit with the tax. As a reference point, the current CBA can be found here in PDF form. The section outlining the Competitive Balance Tax begins on page 83 and is approximately 20 pages in length. It’s a very tough read.
For starters, what exactly is the tax? Basically, the luxury tax is imposed on teams whose total payrolls are determined to exceed a predetermined threshold, set annually in the Collective Bargaining Agreement. The tax is levied on the difference between the total team payroll and the threshold amount. Below are the thresholds for the five years covered under the current agreement:
- 2007: $148 million
- 2008: $155 million
- 2009: $162 million
- 2010: $170 million
- 2011: $178 million
If a team was determined to have a $181 million payroll this season, it would be taxed on ($181-$178), or the $3 million in excess. The actual tax rate is contingent upon past payroll activity, and can be quite confusing. Attachment 27 of the CBA outlines the various tax rate progressions, but here is a basic summary.
The minimum rate is 22.5 percent. The maximum rate is 40 percent. If a team did not surpass the threshold in the year prior to this CBA going into effect, the first time it goes over the tax rate will be 22.5 percent. If a team was over prior to the CBA and over in the its first year of the current agreement, the rate is 40 percent.
If a team is taxed at the 40 percent rate, but falls below the threshold in the following season, before soaring above the year thereafter, it is taxed at a 30 percent rate. If two years of lower payrolls come after a 40 percent taxed season, the rate drops back down to 22.5 percent. It can be confusing, but the only applicable rates are 22.5, 30, and 40 percent. For instance, the Yankees are taxed annually at the 40 percent rate because they are always above the threshold. When the Red Sox were above the threshold last season, they were taxed at the 22.5 percent rate since two years had passed since they were liable.
Teams are informed of their luxury tax liabilities by December 12 of every season, and the balances are due by January 31 of the following season. The big area of confusion with regards to the luxury tax is the determination of total team payroll. It isn’t as simple as taking the sum of each player’s contract in a given year. For luxury tax purposes, the total team payroll consists of the following:
- 1/30th of the team’s player benefit costs
- Player salaries (detailed below)
- Any other amount to be added or deducted (credits from other teams, etc)
The benefit costs include payments on behalf of the player to the MLB benefit plan, workers compensation insurance premiums, unemployment compensation, social security taxes, and any allowances or per diems. The allowances can include moving expenses if the player has to relocate, or spending money while at the all-star game.
For player salaries, the amount to be used isn’t what the player is contractually owed that year, but rather the average annual value of his contract. A back-loaded, five-year deal totaling $65 million — $8 mil in YR1, $12 mil in YR2, $15 mil in YR3-YR5 — would result in $13 mil/yr used in the luxury tax payroll compilation. Front- or back-loading deals is an effective strategy for budget management, but it doesn’t help a team present their payroll in a more favorable light for luxury tax purposes.
For players on one-year deals, their contractually stipulated salary is used. Signing bonuses are also added on an average annual value basis. Joe Blanton received a $6 mil signing bonus in his current contract, but even though the money was received upfront and doesn’t count as part of the Phillies payroll liabilities each season, the team has to add $2 mil each year of the deal to their luxury taxable payroll. However, any bonuses or incentives that trigger in a deal are included in the payroll in the specific year they were earned instead of being straight-lined over the contract.
Contract options work a bit differently. A club option, where a salary becomes guaranteed only if the team decides to exercise it, is not included in the average annual value calculation. If the Phillies had a player signed to a 3-year deal for $30 million, with a fourth-year club option worth $12 million, the average annual value calculation would only use the 3/$30.
Had it been a player option, meaning the money becomes guaranteed if the player decides to exercise it, the AAV includes the option year. In that case, the salary to be included for the luxury tax calculation is $10.5 mil ($42 mil/4 yrs). Mutual options, where either the club or player can guarantee the money, are treated like player options and are therefore included in the AAV calculation.
Vesting options, where the money becomes guaranteed if certain milestones are set, are treated like club options and are excluded from the AAV calculation. If the option includes a buyout amount, and the option is declined, the buyout amount is treated as the equivalent of an isolated one-year deal.
Now, there are a couple of quirks at work here that directly impact the Phillies. The first involves the timing of contract extensions. The second deals with cash considerations received from other teams.
Ryan Howard and his recent contract extension serves as the perfect example of the first quirk. Howard was signed to a 3-yr/$54 million deal that ran from 2009-11, paying $15 mil, $19 mil, and $20 mil, respectively. Howard was then signed to a five-year extension last season paying $20 mil in 2012-13, and $25 mil from 2014-16. Because the extension was signed before his current deal expired, the luxury tax rules stipulate that the years and dollars are consolidated.
Given the luxury tax rules, instead of a 3-yr/$54 mil deal followed by a 5-yr/$125 mil deal (including $10 mil buyout excluded from the calculation), Howard is currently signed to a 6-yr/$133 mil deal: the $18 mil he would make from the prior AAV calculation, added to the $115 mil of the new deal, which doesn’t include the $10 mil buyout in 2017. The AAV computes to $22.17 million.
Basically, because the Phillies extended Howard before the opening day of the final year of his existing contract, they added $4.2 million to their luxury tax payroll this year. The Red Sox avoided this hit when they waited to sign Adrian Gonzalez to an extension until after opening day. It wasn’t that the team and its first baseman couldn’t come to an agreement of terms, but rather that the wait ensured the Red Sox wouldn’t tack on a few million dollars extra in the AAV calculation.
Had the Phillies signed Howard in, say, two weeks, the team would have avoided the steep increase in its luxury tax calculable payroll.
The second quirk can be best exemplified by discussing the Roy Oswalt transaction. When the Phillies acquired Oswalt from the Astros, Ed Wade sent along $11 million with the ace. The credits from other teams do result in payroll deductions, but only in the year they were received. Even though the $11 million was more than what Oswalt stood to make in August and September last season, that entire amount counted towards the team’s compiled luxury tax payroll last season. This is why Jim Salisbury reported that the team receives no benefit this season from the amount of Oswalt’s payroll paid by the Astros: the benefit came last season.
When the Phillies payroll:luxury tax relationship became noteworthy, many were confused because the actual sum of player contracts seemed to be well below the $178 million threshold for the current season. As I described above, though, much more goes into the calculation. It then makes sense that the team would seek hitters owed somewhere in the $2.5-$3.5 million range for the final three months of the season. The team could also spring for a higher-priced player if the need arises and send along a better package of prospects in exchange for the cash considerations necessary to keep it below the tax threshold.
There are multiple scenarios that could see the Phillies adding a player they need while avoiding the luxury tax, though it won’t be easy.
Hopefully this summary helped answer some questions, though I’ll do my best to answer others either in the comments section or via e-mail. It is truly a nebulous part of the CBA, and I am by no means an expert on it. There seem to be various loopholes that might be closed when the new CBA is negotiated, meaning an entirely new summary could be in order at this time next season.
For now, the keys seem to be that payroll for the luxury tax isn’t really payroll as most consider it, and understanding the minutia of the payroll calculation is tantamount to grasping where a team stands with respect to the luxury tax threshold.
Wow, there’s a lot of stuff I didn’t understand or realize. Thanks for putting in the work and explaining clearly what it all means.
Obviously the best thing would be the Phillies not needing to add anybody. Not an impossibility, if the current makeup of the team is any indication. Should be interesting.
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Alright, even if the Phillies have to add a Beltran, is the extra 22.5% really going to kill them?
Clearly they got tax attorneys and not entertainment lawyers to write those rules.
Carlos Quentin (1-yr 5.05M) would seem to fit very easily in the acceptable price range for a 3-month rental. Pence would just fit under the 3.5M too.
What of Lidge’s 1.5M 2012 buyout?
If you’re asking how the $1.5 mil buyout is treated, then it is the same as if he signed a 1-yr, $1.5 mil deal next season. Because it’s a club option, the amount isn’t included in his current AAV, and next year when he most likely bought out, the Phils will pay $1.5 mil and add that amount to their luxury tax payroll.
Excellent, excellent work. What I like about what you guys do around here is make complex concepts understandable and readable, and that is exactly what you have done here.
So do we know what the true payroll number for the Phillies is this year? 174? 175?
Oh, and what’s funny is, if I am reading this correctly, Bobby Bonilla’s crazy deal is counted in the Mets payroll number.
Thanks, Tom. That’s always been my goal in analyzing and was the impetus for my book, Bridging the Statistical Gap. My rough calculations have the Phils at around $175-$176, perhaps higher if certain incentives are reached or benefit costs are above my expectations (I added $1 mil thinking $30 mil total was probably at worst a liberal estimate).
While I don’t have anything real worthwhile to contribute to the discussion, I do feel like acknowledging the work and a thank you for it.
As an excuse to attempt to at least contribute something of worth besides a simple thank you, a little extra reading led me to find that this tax, also sometimes referred to as The Competitive Balance Tax is ironically named. The funds are not dispersed to the allegedly underpriveleged franchises, but rather to international development of the sport. That worthwhile, and important purpose would lead me to believe it will have a long life, if you dare try predict outcomes of collective bargaining agreements.
Who knows what the future holds, but I’ve read a couple not necessarily reliable references that said the Phils do not want to get to the tax point. Kinda reminds me of a person heading to the freezer section of Acme, and habitually buying Breyers because Haagen Daaz is too expensive. Tries it once, and it gets easier and easier to change the buying habit. This winning is too much fun, and if it winds up the course of action needed to skin the cat as our competitive divison, let alone League and sport grow, I’d guess this brand new concern to the brass becomes more secondary than now when it’s new to us. So I guess this primer’s going to require some retention.
Yeah there is a big difference between revenue sharing and the luxury tax. The luxury tax is primarily used to fund the MLB industrial growth fund, as well as the MLB player benefits fund.
I feel like poking my eyes out, because APPARENTLY Kendrick is now the ’5th starter’ until/if Blanton get’s back, which is absolutely a recipe for a lot of unnecessary losses…especially when you consider that the average Kendrick start has a high probability of needing 4 or so innings out of the Bullpen. Not only is he a terrible pitcher anyway, but he’s also spent the season in the bullpen… so his starts may end up being even shorter than last years were.
When I heard Worley was being sent down, I had hoped that it’d just be for a week or so and his spot in the rotation would be skipped until he was deemed ready to come back.
This just seems like a terrible move to me, and I can’t see much of any good coming of it.
Great Article.
We all use Cots to try to guess at these things. Clearly it is much more complicated but not indecipherable.
Is there any site that has the exact correct numbers, and possible wiggle?
Generally, no, because the luxury tax only tends to affect the Yankees, who have no problem paying the tax each season. One thing we’ve thought of doing here, though, depending on what happens when the new CBA comes out, is adding a section in our Contracts page for it. Would that be of interest?
Option buyouts count as signing bonuses if you look more carefully. Big implications for 2011 for the lee and howard contracts, which were not only back loaded but contained big option buyouts. Actually, that combined with the lack of an oswalt discount i’m pretty sure means the phils crossed the lux tax threshold this year (cots opening day has them at 165, oswalt is 7, lee adds over 10 and howard adds two or three. Not to mention additional bonuses to lee and halladay for their cy young awards.), but I guess we’ll find out soon. The new CBA may change things, but that likely has a lot to do with amaro’s stated reluctance to go over the threshold again, given that the double offense counts more.
Jesse, thanks. I had bookmarked this months ago and pointed others to it to explain Howard’s deal, but as I read the CBA more closely I agree with you. I don’t think it’s valid to ignore option buyouts.
However, I think that does allow us to exclude Lidge’s and Oswalt’s buyouts from a 2012 calculation, correct? They would already have been counted by being spread over the guaranteed years of their previous contracts.
One more comment, though I realize these are so late they may not get a response. In reading the CBA, I’m not sure I agree with how the player benefit costs are reflected in this article. Here, it reads as though it’s 1/30th of what the Phillies paid in. Reading the CBA, the wording is something like 1/30th of the total amount paid, with that fraction changing if there are more than 30 teams.
That seems to suggest it’s 1/30th of what all teams paid in, not just 1/30th of what the Phillies paid in. That would greatly exaggerate that figure, and really seems to make it potentially a very big number.
Any information available on what that number actually has been historically? It seems to be a big unknown variable in trying to assess where the Phillies might be for 2012 or any other year.