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The history of the Competitive Balance Tax

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Where did the luxury tax come from?

MLB: JAN 09 MLB Lockout Photo by David J. Griffin/Icon Sportswire via Getty Images

Today, for the first time since the lockout began on December 2, 2021, Major League Baseball will finally make a proposal to the player’s union regarding the core economics issues that are at the center of the current labor strife. At this point, you know what they are: service time, free agency requirements, arbitration, and the luxury tax, to name just a few. Here at Pinstripe Alley, we’ve written quite a bit about these topics and the negotiation between the league and the union, most notably Esteban’s two pieces from early November on the status of the preliminary negotiations and the union’s second offer to the league — two pieces that, unfortunately, still largely reflect the current state of negotiations, considering the fact that they were written two months ago.

But how did we get here? How did these seemingly procedural issues turn into the hot button topics that they are today? Over the next few days, we’re going to take a trip into the history of the “core economics issues,” both within and outside Major League Baseball, to more fully unravel the disconnect between players and ownership. We will begin with something that has been highly relevant to the New York Yankees since its creation in the mid-1990s: the Competitive Balance Tax, known colloquially as the luxury tax.

Perhaps unsurprisingly, the CBT dates back to the sport’s most recent work stoppage, the 1994-1995 players’ strike. Its roots, however, can be found much earlier, in the movements in the 1980s and 1990s to implement salary caps in professional sports, which occurred after the advent of free agency in the 1970s and 1980s.

The owners’ desire for a salary cap is historically very clear. Despite its stated goal of ensuring competitive balance by preventing the richest teams from stockpiling all the best players in free agency, a salary cap — whether a hard cap, like the NFL uses, or a soft cap, such as exists in the NBA — is designed specifically to curtail free agency costs for team owners. With two exceptions, in the very early days of the NHL and in the 1940s for the NBA, salary caps came as a direct result of rising payrolls in free agency. After years of an illusion of free agency that was in essence prevented through heavy draft pick compensation (teams could lose as many as two first round picks for signing one free agent), the NFL finally allowed unrestricted free agency in 1993 in exchange for a cap — contracts, however, remained unguaranteed, as they do to this day.

Major League Baseball was no exception to this trend. During CBA negotiations in 1989, the league proposed a salary cap in a deal that was so team-friendly that it would have been dead on the table even if the union was open to a cap. While the NBA salary cap guaranteed 53 percent of league revenue to the players, MLB offered the players only 43 percent of ticket and broadcast revenue, which themselves made up 82 percent of the overall revenue — some quick back of the napkin math reveals that this offer set the baseline at just 35 percent of overall revenue. Needless to say, this was an absolute nonstarter, and when the 1990 lockout occurred, a salary cap was one of the first demands dropped.

The owners would not accept defeat, however, and attempted to implement a salary cap the next time around, directly leading to the 1994-1995 players’ strike. Ultimately, the league was unable to implement one, and despite misgivings by the union — they believed it would be a cap in disguise — a luxury tax was instead implemented. A compromise between the league’s insistence on a salary cap and the union’s resistance to one, the initial luxury tax penalized the teams with the top five salaries in a given year, fining them for every dollar spent over the mid-point between the fifth- and sixth-highest payrolls. This system was in place from 1997 to 2000, and was allowed to expire after the 2000 season.

Starting in 2003, the luxury tax system returned, largely in the format that is found in today. As part of the CBA negotiation, the league and union set a threshold — originally $117 million, increasing to $136.5 million in 2006. Teams that were above this threshold were charged a 17.5 percent penalty for every dollar over the threshold, increasing to 30, 40, and 50 percent for every subsequent year above it. Subsequent CBAs increased the luxury tax limit (to $162 million by 2009, $178 million by 2011, and $189 million by 2014).

The 2016 CBA saw the first major changes to the luxury tax system since 2002. The increase over the life of the CBA, from $195 to $210 million, was on the low side, although it did actually represent an increase over the increase between the two previous agreements. More significantly, the penalties were increased. Teams that surpassed the threshold by less than $20 million were penalized 20 percent for the first offense, which increases to 30 and 50 percent in subsequent seasons. Exceeding the limit by $20 to $40 million rings up an additional fee (12.5 percent), while teams that surpass it by more than $40 million pay a 42.5 percent penalty and lose 10 spots in the first round of the amateur draft.

Now, does the competitive balance tax actually work as intended? Well, that depends on whether you’re looking at its stated intent or its place in the history of employer/employee relations. Whether or not it actually does as its name suggests and increases competitive balance is up for debate, in large part because what actual competitive balance means is very much in question (for those looking to read into this, there are a healthy amount of articles that can be found on the subject on Google Scholar, although many of them are unfortunately behind a paywall). When viewed purely as a means to limit player salaries, however, the CBT is a resounding success, as team payroll has largely stagnated in the past decade and has dropped since 2017.