Lux tax article from Real GM

["Lance Jacobson" <lancejacob@xxxxxxxxx>]

FWIW, gang, this article may give a bit more insight to the impending,
unending, non-spending cloud of the Luxury Tax that's keeping Gaston from
signing the 13th Celtic. . . or a decent 9th, 10th or 11th, for that matter.



The Brave New World of the Luxury Tax: How Being One Penny over the Luxury Tax
Threshold Might Cost Teams $18 Million

By Dan Rosenbaum

Are you puzzled by the bizarre behavior in the NBA this summer? We have
Toronto, in essence, waiving one of its best players in Keon Clark. We have
Boston trading its starting point guard for Vin Baker who has one of the
ugliest contracts in the league and probably is less effective than Rodney
Rogers who they refused to re-sign. We have Orlando trading Don Reid and a
first round pick for a second round pick. We have Seattle apparently unwilling
to budge past a starting salary of a little more than $6 million for Rashard
Lewis, one of the most promising young players in the league. Practically
every back-up center in the league makes that much, including three back-up
centers for the Sonics.

What is causing this bizarre behavior? Well, the crux of the matter was the
topic of discussion at an arbitration hearing held in New York last week. At
stake in this hearing is the decidedly un-sexy question of how the league will
redistribute luxury tax penalties and escrow funds. This may sound
unimportant, but this redistribution policy could result in some teams paying
a penalty of perhaps $18 million if they sign or re-sign a key free agent.

This is the point at which most readers will click to read the next article
about some sketchy trade rumor, scared away by the possibility that this
article might hurt their head. But for a masochistic minority, this is an
opportunity to think about the brave new world being ushered in by the luxury
tax. (I suspect there are more than a handful of sportswriters and NBA
executives who could benefit from reading this article.)

1. Luxury tax? Escrow funds? What are they?

After years of speculation, the luxury tax is almost a certainty for
2002-2003. In fact, I suspect the odds of the Knicks winning the NBA
championship is higher than the odds of there not being a luxury tax. With
this luxury tax, teams with total salaries over a certain amount, let's call
it the luxury tax threshold, will be "taxed" a dollar for every dollar they
are over this threshold. The luxury tax threshold is estimated to be about $52
million next year. (The exact dollar amount won't be determined until July
2003.)

Current estimates suggest that about 16 of the 29 teams will be over the
luxury tax threshold and will pay around $200 million in dollar-for-dollar
luxury tax penalties. (The Knicks and Trailblazers combined are likely to pay
about $100 million.) In addition to this $200 million, 10% of every player's
salary is put into an escrow account that goes back to the owners if players'
salaries and benefits are greater than 55% of total basketball related income,
such as they will be next year.

This escrow account is estimated to be about $165 million next year, meaning
that about $365 million will be sitting in the vault down at the league office
waiting to be redistributed back to the teams.

2. What happens to all of that luxury tax penalty and escrow fund money?

This is precisely what the arbitration hearing is about.

Right now, the NBA has proposed that all luxury tax penalty money will be
distributed only to the teams under the luxury tax threshold. $200 million
divided by 13 is around $16 million, which would go to the 13 teams under the
luxury tax threshold. Teams above the luxury tax threshold would get none of
this $200 million.

In other words, spend a penny over the luxury tax threshold and that $16
million dollar check with your name on it gets ripped up.

Worse yet, current proposals for redistributing the escrow money are for teams
under the luxury tax threshold to get a 100% share, while those over it get a
70% share in 2003, 40% share in 2004, and 0% share in 2005. In other words,
your redistribution check from the league is likely to be $18 million smaller
in 2003 if you are over the luxury tax threshold.

3. Crossing the luxury tax threshold might cost teams $18 million. How exactly
does that work?

Let's consider the case of Seattle and Rashard Lewis. Suppose that the team
payroll for Seattle is $45.5 million (not counting Lewis), and the luxury tax
threshold ends up being $52 million.

Sign Lewis to a $6 million starting salary, staying under the luxury tax
threshold

-$51.5 million (team payroll)

+$16 million (luxury tax penalty redistribution)

+$6.8 million (escrow fund redistribution - 100% share)

= -$28.7 million (net team payroll)

Sign Lewis to a $7 million starting salary, crossing the luxury tax threshold

-$52.5 million (team payroll)

-$0.5 million (dollar-for-dollar luxury tax penalties)

+$4.8 million (escrow fund redistribution - 70% share)

= -$48.2 million (net team payroll)

In other words, increasing Rashard Lewis's starting salary by just $1 million
may increase Seattle's 2002-2003 net payroll by $19.5 million. Notice,
however, that most of the "penalty" for crossing the luxury tax threshold is
due to reductions in the net payroll for teams under the threshold rather than
increases in payroll for teams over the threshold.

Looking at this, is there any mystery why Seattle's negotiations with Lewis
have been so long and arduous?

4. Losing $18 million for going over the luxury tax threshold is a far bigger
penalty than the dollar-for-dollar penalties that have been heavily
publicized. It is almost like a second luxury tax, isn't it?

This is precisely the argument made by the players in this arbitration
hearing. They are arguing that this redistribution plan violates the spirit of
the Collective Bargaining Agreement signed after the last strike in 1999.
However, the language in the document signed by both the players and owners
states that luxury tax penalties and escrow funds "shall be the exclusive
property of the NBA, and the use and/or disposition of all such amounts,
including the allocation or distribution of such amounts to one or more NBA
Teams, if any, shall be within the NBA's sole discretion." I am no lawyer, but
it seems to me that a fair interpretation is that the NBA can do whatever the
hell it wants with this money.

5. Losing $18 million is just too big of a penalty. Is this the only estimate
out there?

No, Phil Miller of the Salt Lake City Tribune and Frank Hughes of the Tacoma
News Tribune and ESPN have reported smaller penalties of around $7-$9 million.
However, these estimates imply that more than $100 million will not get
distributed back to the teams. Leaving such a large amount down at the league
office seems implausible.

Perhaps, more importantly, the $18 million depends on estimates of the luxury
tax penalties, escrow funds, and the number of teams over the luxury tax
threshold. The most important of these parameters is the number of teams under
the luxury tax threshold. If only 10 teams are under the threshold (probably
the bare minimum), then the penalty likely would balloon to over $23 million.
If 16 teams are under the threshold (probably the absolute maximum), then the
penalty would be only about $14 million.

One last note on this issue. I have spoken with a team executive who is an
expert on these issues, and he claims that a final decision on the
redistribution policy has not been made. He insists that the policy is
determined by a vote of all 29 teams and that it is very possible all 29 teams
get an equal share. (This would eliminate the penalty for crossing the luxury
tax threshold.) This claim is at odds with the purpose of this arbitration
hearing, so I am a little skeptical.

6. How are teams reacting to the possibility of losing $18 million by crossing
over the luxury tax threshold?

First of all, $18 million is what teams receive from 8,763 fans plopping down
the average ticket price of $50.10 for every regular season game. Another way
to think about this is that $18 million is about half of the ticket revenue
that the typical owner receives for the whole season. Even the lower $7-$9
million estimates are huge amounts when viewed in this light.

Avoiding this $18 million penalty (or $7-$9 million penalty) can explain many
of the anomalies of this free agent season.

  a.. Seattle has been unwilling to budge past a starting salary of a little
over $6 million for Rashard Lewis (just a little more than Eddie Robinson
received the year before). Guess what, offering Lewis anything more would
likely put Seattle over the luxury tax threshold. Is Lewis worth losing out on
$18 million?
  b.. Instead of re-signing Rodney Rogers, Boston decided to take on the $56
million left on Vin Baker's contract and get rid of their starting point
guard. While this move likely hurt the Celtics on the basketball court, it
shaved $1 million plus the $3-$5 million to re-sign Rogers off of their
payroll. This move makes it possible for them to slip under the luxury tax
threshold, possibly saving them more than $18 million. Does it seem like such
a lopsided deal from that perspective?
  c.. San Antonio traded two key players in their rotation last year (Antonio
Daniels and Charles Smith) for a player that rarely left the bench for them
two years ago (Steve Kerr). This move saved them about $1.4 million, likely
putting them a hair below the luxury tax threshold.
  d.. Toronto, in essence, waived one of their best players in Keon Clark,
while other teams that needed help in the frontcourt, such as Miami and
Orlando, made practically no effort to sign him. All three of those teams,
unlike Sacramento, are right around the luxury tax threshold and simply could
not justify losing out on $18 million just to sign Clark.
  e.. Orlando traded a player with a one-year contract and a first-round pick
for a second-round pick, saving themselves only $1 million. But it also kept
them under the luxury tax threshold and perhaps $18 million richer.
7. What do you expect to see in the future?

First of all, there is no guarantee that there will be a luxury tax forever.
It is highly likely for 2003-2004, but after that it is less likely. (If teams
like Phoenix keep handing out max contracts to players like Shawn Marion then
all bets are off, and the luxury tax probably is a reality from now on.) But
keep in mind that part of this penalty for crossing the luxury tax threshold
is due to the redistribution of the escrow funds - the part of the penalty
that is legislated to increase over time and is likely to be in effect even if
the luxury tax is not in effect.

Expect negotiations to become far more contentious. In the past, competition
between teams forced teams to move quickly, leading to a flurry of signings in
July. Now, many players' options are limited to their own cost-conscious
teams, and negotiations are much more drawn out. Even next year, when more
teams are under the salary cap, expect negotiations for all but a handful of
players to be long, drawn-out affairs. I would be amazed if all of Indiana's
free agents (Jermaine O'Neal, Brad Miller, Ron Artest, Jonathan Bender, and
Reggie Miller) are signed by the start of the regular season in 2003-2004.

Also, expect to see teams make more trades like the Orlando trade of Don Reid
for pure salary dumping reasons. Only teams under the salary cap or with large
trade exceptions can offer teams an opportunity to dump salaries in large
amounts, and this year only the Los Angeles Clippers are significantly under
the salary cap. Perhaps a Ron Artest or Wally Szczerbiak for a draft pick
(even a second round draft pick) might make sense if Indiana or Minnesota are
a million or two above the luxury tax threshold. Next summer, when several
teams are under the salary cap, there might be lots of trades of this sort.

Expect to see teams well over the luxury tax threshold to be more willing to
spend than those near the threshold. Once a team is clearly over the luxury
tax threshold, the only deterrent to additional spending is the
dollar-for-dollar luxury tax. For example, signing Keon Clark for $4.5 million
costs Sacramento twice what they are paying him, i.e. $9 million, whereas for
Toronto or Orlando, signing Clark may have cost them perhaps $27 million,
because he may have pushed them over the luxury tax threshold. Thus, you will
see teams, like Sacramento or New Jersey, who figure that since there is no
way they can get under the luxury tax threshold, they might as well take
advantage of the bargains out there.

Along these lines, Phoenix is by far the most bizarre case. Last year, they
were shedding large contracts - getting rid of Cliff Robinson, Rodney Rogers,
and Tony Delk for not much more than Joe Johnson and a draft pick. This
summer, they added Scott Williams and extended Shawn Marion to a max contract
- guaranteeing that they will be paying luxury taxes this year and next, while
being very close to the threshold in later years. Apparently, the dramatically
lower salary cap converted them from being a penny-pinching team near the
threshold to a we'll-pay-our- players-what-we-have-to team over the
threshold.

8. So what is the bottom line?

The luxury tax is ushering in a brave new world, and we are only starting to
see how dramatically it will change the NBA. And, believe me, the changes will
be dramatic. Some teams appear to be much more fully aware of the implications
of this new world that others. The front office executive cited above claims
that many NBA teams do not have front office personnel with the legal and
financial expertise to sort out all of the possibilities brought on by the
luxury tax. As a Ph.D. in economics who studies how individuals and firms
respond to incentives, this behavior is utterly amazing. I would have guessed
that $18 million was a powerful enough incentive to encourage all teams to
hire such personnel, but I guess not. Thankfully, it's not my $18 million (or
even $7-$9 million) that some owners are throwing away like used candy
wrappers.