Let's Talk About Luxury Tax and the Red Sox

One thing that always gets discussed in depth during the offseason is the dreaded MLB Luxury Tax (also Competitive Balance Tax or CBT).  There's a lot of easy to misinterpret and just incorrect information out there about what exactly the tax is and how it is calculated. 

Theo Epstein has publicly stated that one of his goals for the year is to remain below the Luxury Tax threshold, so since this is going to be a significant factor in the Red Sox offseason, let's take a quick look at what exactly the luxury tax works, and how it is going to affect the Red Sox going into 2010.  There are some things here I will gloss over a bit and some things that I will go into depth on because I'm trying to keep this as relevant to the Sox' current situation right now without actually going the 20 pages in the CBA.

First off, let me start by saying that all of this is available in the current MLBPA bargaining agreement, in Article 23, starting on page 83.  It's written in legalese, and I'm no lawyer, but I'm doing my best to interpret the relevant parts here for our sake.  If anyone else cares to read through it and finds that I'm misinterpreting something, please let me know, I'm not entirely infallible.

First, the thresholds are seen many places and easy to breakdown.  The ones remaining are:

2010 $170 Million

2011 $178 Million

TAX RATES

Now the rates that teams have to pay these rates are 22.5%, 30%, and 40%.  Each time a team exceeds the threshold, they have to pay in the next highest bracket, with 40% being the maximum.

 For example, if the Marlins went all out and somehow spent an extra $150 million this offseason, they would exceed the threshold for the first time- this year they would have to pay an extra 22.5% of everything past the threshold.  In 2011, however, if their payroll once again exceeded the threshold ($178 million), they would have to pay an extra 30% for each dollar over the threshold.

There is another side to this which frequently gets left out and is very relevant to the Red Sox at the moment.  If a team does NOT exceed the threshold for a year, they drop to the next lowest tax bracket, except that teams stick at the 30% bracket for two years of not being over.

As I said, this is VERY important for the Red Sox.  The last time the Sox exceeded the threshold was 2007, when they were subject to the 40% tax bracket.  This means that in 2008, they would have again been subject to the 40% rate, but since they were under the threshold, it meant that their bracket lowered.  In 2009, they would have been subject to the 30% rate, but again stayed under the threshold.  Now, in 2010, if the Red Sox go over the threshold, they will be subject to the 30% rate in 2010 and will jump to the 40% rate in 2011.  If, however, they avoid going over $170 million in 2010, then in 2011, they will only be subject to the 22.5% tax rate.

What does this mean for the Sox?  Obviously, it makes it very clear why the Red Sox want to stay under this year- it means that in the future, they will be able to go over for a couple of years without being subject to the rate.  If the payroll just barely exceeds the threshold, it still jumps, so since the Sox are likely to only make another couple of moves, it doesn't make sense for them to make a move that will push them just over the threshold.  This is one reason why for 2010, the threshold is a huge sticking point.

PAYROLL CALCULATION

This brings us to another point which is people saying that the team payroll right now is sitting significantly under $170 million, so what is even the worry?

There are a few sticking points which greatly affect this.

First, the payroll for the sake of Luxury Tax also includes 1/30 of the total cost of player benefits (the benefits are split between the teams).  For 2010's sake this is $10.5 million.

Second the Luxury Tax is calculated based on contract average value, not the actual year's cost.  This means that since Lester signed a 5 year/$30 million contract, although he is being paid $3.75 million this year, for the sake of Luxury Tax, he counts as costing $6 million a year.  This number also includes signing bonuses split over the life of the contract, so if a player signed a 3 year/$3 million contract but was given a $15 million signing bonus, he would also count as being $3 million each year for the CBT.  So again, backloading or frontloading contracts does not affect the CBT.

Third, the number still includes players salaries we are paying, and includes buyouts of player's options.  So this year, the Sox still count as paying Lugo as well as the buyouts of Wagner and Saito.  If a player is traded, for the sake of CBT, we count as paying the amount we actually paid- so if the Lowell trade had gone through, we would have been on the hook for $9 million as far as CBT was concerned, not the full $12 million.  If we trade for a player, we are on the hook for the actual amount we pay them.

Fourth, though this is more minor, when a team brings someone up from the minors, the CBT includes their salary pro-rated for the amount of time they spent with the major league club.

Also, this number includes performance bonuses in players contracts. 

 Between all these points, it means that although the opening day payroll for the Sox in 2009 was $ 121,745,999, for the purposes of CBT, it ended up being $140.5 million.  So as you can imagine, the Sox are quite worryingly close to the line right now.  The breakdown here seems pretty accurate, though the arbitration numbers are guesses.  Also note that the breakdown only includes $9 mill for Lowell, meaning the Sox had better shed some salary or they'll be jumping a tax bracket.

WHERE DOES THE MONEY GO?

Not the government, for sure, not that kind of tax.  Also not to the poorer teams, as the name Competitive Balance Tax would have you believe.  The money goes to an industry growth fund (edited for incorrectness).

EDIT: looks like my information about where the money goes was not entirely correct, so let me correct it here.

The first $5 million is held in reserve in case the amount is changed and a CBT Refund needs to be issued.  If no refund is needed, this is then sent to the Industry Growth Fund

75% of the money goes towards paying players benefits.

25% goes into the Industry Growth Fund, which I can't find tons of info on right now, except that their money goes towards:

1. licensing, advertising, marketing

2. International development

3. New Media Technology

4.Community Service

5. Promotion for clubs which have received revenue sharing

So some of the money DOES in fact go to the smaller market teams.  My understanding also is that since they teams split the cost of the benefits and then the CBT goes 75% to paying player benefits, that means that most of the $26 million the Yankees are paying will go towards paying player benefits, thereby reducing what everyone else is paying, though admittedly by a small amount.  This is just my understanding, I could be off on this.

That's my basic quick rundown for now.  If anyone has any other thoughts, anything to add, or any questions, put them in here.  Hopefully this provides some useful information and some perspective on what the Sox are doing this offseason.