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The N.B.A. has embarked on a grand and peculiar experiment to alter the league's financial structure through a luxury tax. The system has changed the league, but perhaps not in the manner envisioned by its architects.
In 2002-3 and 2003-4, the tax redistributed $680 million from players and high-spending owners mostly to low-spending owners.
That $680 million equals one-eighth of total N.B.A. revenue over these two seasons and dwarfs the $80 million redistributed during the five years of Major League Baseball's luxury tax. (This does not include its revenue sharing.) N.B.A. welfare for low-spending owners even surpasses the cash welfare systems in 30 states.
The figures are large, but the system is complicated and poorly understood by some teams. It takes effect only if player salaries and benefits top 57 percent (55 percent before this season) of the league's basketball-related income.
When that happens, the league first taxes players to make up the difference by taking up to 10 percent of their salaries. But if this escrow tax is not enough to make up the difference - and it wasn't in 2002-3 and 2003-4 - then the luxury tax is triggered. (Note that this season, because of an accounting quirk, the luxury tax is unlikely to be triggered.) That imposes a 100 percent tax on teams for every dollar they spend above the luxury-tax threshold, which depends on revenue and is roughly the average team salary.
The $680 million collected created an additional spending disincentive. The formula for the distributions resulted in an effective tax rate in excess of 300 percent for the first $3 million to $4 million of spending above the luxury-tax threshold. Adding $4 million in salary for a team just below the luxury-tax threshold cost teams almost $17 million, but the same move cost a high-spending team $8 million.
This creates a de facto "hard" cap for teams without deep-pocketed owners. For example, two summers ago Indiana - a championship-contending small-market team - had to consider future luxury taxes when giving up Brad Miller, a young All-Star center. This season, the San Antonio Spurs were eager to unload the expensive contract of the fan favorite Malik Rose, who is now on the Knicks.
The luxury tax has not only discouraged spending by many teams, but also transformed the N.B.A.'s profit structure, perhaps much more than the system's designers envisioned in 1999. The system doesn't equalize profits across the league; it instead extracts high rents from wealthy, ambitious owners.
Three teams, the Mavericks (Mark Cuban), the Knicks (Cablevision) and the Trail Blazers (Paul Allen), redistributed $180 million to the rest of the league in 2002-3 and 2003-4 and had combined losses of about $200 million. In the two seasons before the luxury tax, these teams nearly broke even.
On the other hand, 13 teams - Chicago, Cleveland, Detroit, Denver, Golden State, Houston, the Los Angeles Clippers, New Orleans, Orlando, San Antonio, Seattle, Utah and Washington - received much of the redistribution (about $227 million) and increased profits to nearly $600 million from about $200 million. Staying under the luxury-tax threshold has become more profitable than winning.
One peculiar feature of the N.B.A.'s system is that teams don't know the precise luxury-tax threshold or even whether the luxury tax will be triggered until after the season. This may tempt teams to game the system by manipulating revenue to avoid triggering the luxury tax. More important, teams must make salary offers without knowing the luxury-tax costs. This uncertainty implies that accurate luxury-tax forecasts could save teams millions of dollars, yet many teams conduct only rudimentary analyses. Even the players union, for which I have been a consultant, spends scant time on forecasting.
As Steve Patterson, president of the Blazers, points out, forecasting the luxury tax "requires complex models" of leaguewide revenue in addition to team-by-team salary levels several years into the future. Teams may dislike this uncertainty, but "like the three-second call," he says, it is "one of the rules we all work under."
Given the distortions and uncertainty created by the luxury tax, how does it affect teams and players? Spending that leads to victories for high-spending teams creates losses for other teams. The luxury tax raises the costs of spending, resulting in high-payroll teams implicitly taking into account the negative effect their spending has on other teams. The luxury tax also helps level the playing field for teams across the league.
In addition, players may prefer the luxury tax to other cost-control options like a hard salary cap, because by extracting rent from the wealthiest, most ambitious owners, the luxury tax probably maximizes the revenue for the players over the long term. Such tax payments also increase the share going to a majority of the owners. On the other hand, it could lead to animosity if high-spending owners come to resent owners whom they perceive as having little interest in improving their teams.
In the end, the luxury-tax system is a large and quirky experiment. It has changed the N.B.A., even if its effects are not yet fully understood.
Dan T. Rosenbaum is an assistant professor of economics at the University of North Carolina at Greensboro.