An Analysis of the Nba Luxury Tax

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An Analysis of the Nba Luxury Tax IS IT BETTER TO GIVE OR RECEIVE? AN ANALYSIS OF THE NBA LUXURY TAX. A THESIS Presented to The Faculty of the Department of Economics and Business The Colorado College In Partial Fulfillment of the Requirements for the Degree Bachelor of Arts By Ricky Boebel April, 2015 1 IS IT BETTER TO GIVE OR RECEIVE? AN ANALYSIS OF THE NBA LUXURY TAX. Ricky Boebel April, 2015 Mathematical Economics Abstract The results showed that teams that project themselves to have a winning record should breach the tax threshold. However, these franchises should not pay beyond one standard deviation of the average tax figure in a given year. Teams that project themselves to have a losing record should stay under the threshold. This is surprising as many franchises, particularly those in small markets, often go to drastic lengths to stay below the tax to the detriment of on and off-court performance. Over the period studied, an average of 6 teams paid the tax. The model found that regardless of market size around 15 teams per year would increase franchise net worth by having payrolls above the tax. KEYWORDS: (NBA, Tax, Salary Cap, Net Worth) JEL CODES: (A100, C120, J000) 2 ON MY HONOR, I HAVE NEITHER GIVEN NOR RECEIVED UNAUTHORIZED AID ON THIS THESIS Signature 3 TABLE OF CONTENTS Abstract ................................................................................................................ 2 Acknowledgements .............................................................................................. 5 Introduction ........................................................................................................... 6 Luxury Tax Overview ............................................................................................ 7 Literature Review .................................................................................................. 9 Dataset ............................................................................................................... 14 Model .................................................................................................................. 17 Results ............................................................................................................... 20 Conclusion .......................................................................................................... 26 References ......................................................................................................... 28 Appendix ............................................................................................................ 29 4 Acknowledgements Firstly, I’d like to thank my thesis advisor Neal Rappaport for guiding me through the process with positivity and thoughtfulness. I would also like to thank my Father, without his ever growing PhD-sized shadow driving me, this paper may have never have been finished. Also deserving of acknowledgement is my Mother and the many chickens she maintains to this day, especially Todd. To my Dell Latitude E6420 laptop, I thank you for your four years of service. While you may have failed me in the middle of this thesis, I’ll always remember the good times when you could still turn on. Lastly, I’d like to thank NBA Commissioner David Stern, your tenure in the league was defined by your style and grace and without you this paper’s topic may not exist. 5 Introduction The luxury tax is a mechanism of controlling team spending in the NBA. For every dollar a team exceeds the league set threshold, it pays a dollar back to the NBA and other non-tax paying franchises. Since its introduction in the 1999 Collective Bargaining Agreement (CBA) teams have paid over a billion dollars in luxury taxes. This paper asks the question: does paying the tax increase or decrease team net worth? And is this effect dependent on team performance? The results showed teams that project themselves to have a winning record should breach the tax threshold. However, these franchises should never pay much beyond one standard deviation of the average tax payment. Teams that project themselves to have a losing record should stay under the threshold. These results are somewhat surprising as it suggest that teams should be more willing to pay the tax than they are currently. Franchises, particularly those in small markets, often go to drastic lengths to stay below the tax, often to the detriment of on-court performance. Over the period studied, an average of 6 teams per year paid the tax. My data states that regardless of market size around 15 teams in a given year would be positively affected by passing the tax threshold. 6 Luxury Tax Overview There are a number of ways professional sport leagues choose to control player salaries. The National Football league sets a hard salary cap that cannot be exceeded by any team. The English Premier League has no salary cap allowing teams to spend according to their means. The NBA attempts to find a compromise between these two cap structures with the luxury tax, also known as a soft salary cap. As it is currently structured, the league office sets the tax level before the season based on the NBA’s projected Basketball Related Income (BRI). Under the CBA that was negotiated in 2011, players’ salaries must account for approximately half of all BRI. In 2014, the league set the tax threshold by projecting 53.51% BRI then subtracted projected benefits (primarily used for player pension plans) and divided by the number of teams in the NBA (30), which totaled to a $71.75 million tax threshold. The teams with payrolls over the threshold must pay a tax back to the league depending on the quantity they went over the tax. For example, last season the Brooklyn Nets had a payroll of $106.5 million, $34.75 million over the tax threshold. Because of the escalating incremental system they paid a $90.57 million in taxes. Below is a table of the five teams that exceeded the luxury tax in 2014. Notice the wide range between the maximum and minimum tax payment. 7 Figure 1: 2013-2014 Luxury Tax Teams TEAM Tax Paid/Received (millions) Brooklyn Nets $ 90.60 New York Knicks $ 36.30 Miami Heat $ 14.40 Los Angeles Lakers $ 8.90 Los Angeles Clippers $ 1.30 Tax redistributed per $ 3.03 team The funds from the luxury tax go one of two places. It can be designated for “league purposes” or up to 50% can be issued to the non-taxpaying teams. For example, last year $151.5 million was paid in luxury taxes. The league decided to issue the maximum 50% to the non-taxpaying teams, meaning they divided half of the total tax into 25 equal payments to the franchises with payrolls below the luxury tax threshold. In all but one year, the 2011-2012 lockout season, the commissioner's office has issued the maximum of 50% to the non-tax paying teams. Several changes have been made to the luxury tax system since its inception in 1999. In its first 6 seasons, the tax was triggered just twice (2003 and 2004). Many believe this was because the exact luxury tax threshold was not set until after the 8 season. This changed in 2005, when the newly negotiated CBA mandated that the tax threshold be set before the season, based on a projection of BRI by the league office. This is a major development as it gave teams an exact tax threshold before making personnel decisions, thus eliminating the possibility of teams accidentally paying the tax. Until the 2011 CBA the tax had been very simplistic, for every dollar a team went over, a dollar was paid to the league. In 2011, the league introduced an incremental tax rate as shown in the table above. Here, franchises are charged a gradually increasing tax rate as they go over set payroll ranges. Furthermore, a repeater penalty was put in the agreement that mandated teams pay a higher still repeater tax rate if they overstep the threshold in three of the past four seasons. However, it is impossible to identify the effects of this repeater rate currently as there have only been three seasons since the latest CBA was enacted. Literature Review Empirical economic research on the NBA’s luxury tax system is fairly limited due to its recent inclusion into the Collective Bargaining Agreement (CBA). Baseball was the first professional sport to implement a luxury tax in the mid-1990’s. Ajilore and Hindrickson (2005) found that the luxury tax has led to greater competitive balance in Major League Baseball. In reference to this paper, the result implies that tax paying teams would not see a jump in performance. Ajilore and Hindrickson contend 9 that the redistribution of funds to smaller market teams would result in increased competitive balance as smaller teams would increase spending due to the additional income. However, the distribution of wealth in Major League Baseball (MLB) differs greatly from that of the NBA. The MLB tax rates are a fraction of the NBA’s, yet teams are still less willing to exceed the tax threshold in baseball. Since 1999, 22 NBA franchises have paid the tax versus five in the MLB. While the baseball system is different, it is the most comparable salary cap structure to the NBA’s luxury tax system. Dietl et al(2009) analyzed luxury taxes from a holistic viewpoint, creating a mathematical model of how luxury taxes affect competitive balance, social welfare and team profits. This model was purely theoretical and did not focused in on one sports league in particular. The authors concluded that profits should increase for both small and large market teams provided the tax is set at a low enough level for large market teams to exceed it and pay back into the
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