Wednesday, July 06, 2005

How will the new NBA collective bargaining agreement and new luxury tax rules affect the free agent market?

By Dan T. Rosenbaum

The league and the union are still hammering out details on their new collective bargaining agreement (CBA), but heading into crunch time, it appears that the league is making a game of it. The league got concessions on a handful of non-economic issues, but the economic issues tended to fall in the players' favor. This new deal removes some of the teeth from the luxury tax (how much is still an open question), but guarantees a luxury tax in every season and at a lower threshold than in this past season. The salary cap increase likely will more than offset the changes in maximum contract lengths and raises.

Overall, I am now uncertain how to assess this deal. If the luxury taxes are evenly distributed to all 30 teams, then this was a big win for the players who will likely receive more than 60 percent of basketball-related income (BRI) over the life of this agreement - an outcome that will put a lot of pressure on owners during the next round of negotiations.

If the luxury taxes are distributed in some other way, then I think this it is very possible that this deal was pretty fair for both owners and players.

First, let me lay out the major provisions of this new deal. (I borrow heavily from David Lord at DallasBasketball.com here.) The provisions in green should significantly increase the overall compensation of the players, while those in red should decrease them.

  1. The luxury tax will stay as is - dollar-for-dollar on teams above the 61.1% of BRI threshold used prior to 2004-05, except that the new deal guarantees that the luxury tax will be triggered in every season of the deal. [Note that this season the threshold was at 63.3% of BRI.]
  2. All teams (including those who pay tax) under the new deal will receive a full share of the escrow tax collections. I have seen conflicting reports of what will happen with luxury tax collections. [In the old deal, they received amounts that were reduced or eliminated entirely, according to their spending level.]
  3. Luxury Tax Amnestry Provision (Allan Houston Rule): This summer, teams will be given a one-time opportunity to waive one player and eliminate the luxury tax on any future contractual payments to that player. The salary will still count towards the salary cap, and payment will still have to be paid to the player according to the contract, but the team will not be subject to tax on that player’s contract. [Speculation is that this luxury tax amnestry provision will also apply to previously waived players, but not players traded for after June 1st.]
  4. Luxury tax exceptions will be added in some as-yet-undisclosed fashion for minimum salary players.
  5. The salary cap and luxury tax exceptions for players who are deemed ‘permanently injured’ will begin after one year rather than two.
  6. The escrow tax on player salaries will be reduced from 10% in year one, to 9% in years two through five, and to 8% in year six of the agreement.
  7. The players will be guaranteed a total of 57% of BRI each year, up from no guarantee. [I believe this guarantee increases in some as-yet-undisclosed fashion as overall league revenues increase.]
  8. The escrow tax will only be retained by the owners to offset salary costs when total salaries exceed 57%, just like in the last season of the prior deal, but in the new deal that threshold will be raised if overall league revenues increase in some as-yet-undisclosed fashion.
  9. The salary cap will be set at 49.5% iof Basketball Related Income (BRI) in 2005-06 and 51% thereafter, up from 48.04%. That means last year's salary cap of $43.87 million will likely go up to the $49 to $50 million range this summer, once revenue increases are factored into the equation. [Presumably, maximum salaries will increase, since they are tied to the salary cap.]
  10. Gilbert Arenas Provision: Restricted free agents in their first two seasons can be offered contracts above the MLE by teams with salary cap room, but in the first two seasons of such deals players will be paid the MLE. After the second year of the contract, the contract can increase to the maximum allowable salary for that player. This provision allows a player's original team to match any offer and retain him as long as they have their MLE available. Example: Suppose Chris Duhon is offered a contract of $10 million, $10.8 million, and $11.6 million in years 1, 2, and 3. He would be paid the MLE in the first two seasons and $11.6 million in year 3. But only a team with $10 million in salary cap space could offer such a contract. [Presumably, the cap holds in the first two seasons of such contracts are $10 million and $10.8 million and not the MLE. It is unclear how the luxury tax would apply to such contracts.]
  11. A team will have 7 days to match an offer for a restricted free agent (down from 14).
  12. The maximum length of a new contract will now be 6 years for a player who signs with his current team (down from 7), and 5 years for a player who signs with another team (down from 6).
  13. The maximum annual raises on a new contract will now be 10.5% of the first-year salary (not compounded) for a player who signs with his current team (down from 12.5%), and 8% for a player who signs with another team (down from 10%).
  14. First-round picks will be given standard contracts with two years guaranteed (down from 3), followed by two years of team options (up from 1). The contract amounts will remain standardized. [Presumably, the option for year 3 would have to be picked up prior to year 2. This is very early to give up on a rookie, so it is likely that teams would decline this option very rarely.]
  15. There are no changes being made to the general salary cap exception mechanisms which allow teams to exceed the salary cap to add players, such as the Bird Exception, Million Dollar Exception, Mid-Level Exception, etc. [I presume there could be changes to the formulas used to compute these exceptions.]
  16. For teams over the salary cap, trades will be allowed as long as they trade away as much first-year salary as they receive within 25% (up from 15%) + $100,000.
  17. Base-year compensation (BYC) rules, for trades involving players who just received a sizable raise, will be relaxed in some as-yet-undisclosed fashion. [I have heard that BYC status will end at the end of the moratorium the following season rather than a full calendear year later.)
  18. Minimum salary levels will be increased by 3.5%.
  19. Teams will be required to have an average of 14 players (up from 11) under contract. [I have heard teams will be required to have 13 players with an unknown maximum. I am not sure what mechanism there will be to guarantee an average of 14 players.]
  20. The active roster will still be limited to 12 players, but the designation for the others will now be ‘inactive’ rather than ‘injured.’
  21. The NBA age limit will be 19, and one year past high school for Americans, based on calendar year. [There is likely to be a related league rule implemented that prohibits NBA scouts and personnel from scouting any high school games.]
  22. The NBA Developmental League (NBDL) age limit will be 18, down from 20.
  23. Teams will be able to send players with less than two years experience to the NBDL for needed development during the year, while still retaining full rights, with the ability to recall any such player at any time as desired. Such players will receive their full NBA pay.
  24. Teams will be able to send an assistant coach to their associated NBDL team to work with and monitor the development of their players.
  25. Players will be subject to as many as 4 random drug tests per year (up from 1), with penalties increasing for failing a test on a 4-strike system (5-10 games, 25 games, 1 year, lifetime).
  26. Suspensions for on-court misbehavior will be subject to arbitration if the penalty exceeds 12 games (formerly there was no arbitration regardless of length).
  27. There will be a longer-than-usual July moratorium this summer, as the wording on the deal is hashed out, but summer leagues and negotiations with free agents will be allowed to take place during that time without interruption. No new contract signings (except for draft picks) can take place until the moratorium ends this summer.
  28. More money will be added to pension payments for the older retired players, pending approval under IRS regulations.
  29. New rules begin with the new season that starts July 1, 2005.

On the economic issues, the league was able to reduce the lengths of guaranteed contracts and the size of maximum raises, which they believe will rein in costs. But I think rather than reducing costs, these changes will simply redistribute compensation from unproductive to productive players. That is a good thing for both sides (and for fans). Moreover, for maximum salary players these changes in guaranteed contracts were largely mitigated by the increase in the salary cap, which increases maximum salaries. In addition, the increase in the salary cap will increase the number of teams able to offer large contracts, which will push up salaries for all players. All in all, I think this set of changes will increase the share of revenue going to the players, but not by much.

It is the luxury tax (and salary cap) provisions that will most affect league-wide player salaries. The league did get a lower threshold for the luxury tax - the 61.1 percent of BRI threshold used in 2001-02 through 2003-04, which is down from the 63.3 percent used in 2004-05. Also, the new deal guarantees a luxury tax in every season. Altogether this lower luxury tax threshold and certainty of the luxury tax being triggered should help control spending.

That said, the big enchilada in this deal is the change in how luxury and escrow taxes are distributed back to the teams. In the old deal the bulk of the $300 million or so a year (in luxury and escrow taxes) went to teams below the luxury tax threshold. This resulted in the first $3 to $4 million spent above the luxury tax threshold costing teams $3 to $4 million in luxury taxes and $8 to $10 million in lost distributions. That, in effect, was a 300 to 400 percent effective tax rate for spending just above the luxury tax threshold. That got teams attention and for some teams made the luxury tax threshold a "hard cap."

In the new deal, escrow taxes reportedly will be distributed evenly to all 30 teams. It is uncertain how luxury taxes will be distributed. Under an even distribution of luxury taxes to all 30 teams, the effective tax rate would only be 100 percent for spending just above the luxury tax threshold. This lower effective tax rate would result in more teams blowing past the luxury tax threshold when they believe that an extra player or two significantly increases their chances of success.

Under a distribution tilted towards teams below the luxury tax threshold, we may see the return of effective tax rates above 100 percent. They almost surely will not reach the 300 to 400 percent effective tax rates in the old deal, but even a 200 percent tax may be enough to rein in spending for many teams. It is possible that the league also could reduce distributions only for teams spending well above the luxury tax threshold. This would, in effect, be a back-door "super tax."

Added to this, the luxury tax amnesty provision and luxury tax exceptions for injured players and minimum salary players will reduce the exposure of high-spending teams to the luxury tax. By being able to shield tens of millions of salary from the luxury tax, these teams will feel more free to spend on new players. Also, the players waived under the luxury tax amnesty provision will result in additional "good" players in the free agent market. This also will increase the demand for teams to spend more.

Together these provisions along with an even distribution of the luxury taxes would remove the teeth from the luxury tax, resulting in more teams being willing to pay a little luxury tax and in high-spending teams feeling more free to be aggressive in their free agent and trading activity. (The relaxation of trading rules also will help aggressive teams in this regard.)

But again, a lot of this hinges on how the luxury taxes are distributed. The luxury tax tiger may not have lost all of its teeth.

And as mentioned above, the salary cap will increase significantly, which will result in more teams below the salary cap and teams below the salary cap having more money to spend. If the luxury taxes are distributed evenly, the luxury tax changes will result in middle- and high-spending teams being more aggressive in the free agent market, while the salary cap increase will result in lower-spending teams being more aggressive.

All told, if luxury taxes are distributed evenly to all 30 teams, these changes should result in players' salaries rising signficantly. (And this ignores the reduction in escrow tax over the life of the deal.) Counting all salaries (including those for injured players that do not count towards the salary cap), here is the share of BRI that players received the last few seasons and my predictions for 2004-05 through 2006-07.

Players' Share of BRI (After Escrow Tax is Paid) Under Even Distribution of Luxury Taxes

  • 2002-03: 60.1%
  • 2003-04: 59.3%
  • 2004-05: 58.1%
  • 2005-06: 61.7%
  • 2006-07: 60.3%

As you can see, the players' share of BRI had been declining under the old deal as teams "got religion" about the luxury tax. But if luxury taxes are distributed evenly, my prediction is that the new deal will undo much of the spending restraint of the old deal, resulting in the players' share of BRI rising above 60 percent. That will put pressure on owners to drop that percentage in the next round of CBA negotations, six years from now.

If luxury taxes are not distributed evenly, then the effect on the free agent market and players' share of BRI would depend heavily on how they distributed the taxes. But my guess is that under this scenario, the players' share of BRI would be much less likely to rise above 60 percent.

But that leads to an obvious question. If the luxury taxes being distrubted evenly would so result in the deal lopsidedly favoring the players, why would the owners sign off on this deal?

Well, first of all, I don't know if the owners have formally signed off on this deal and Chad Ford of ESPN.com has reported that negotiations over details to the new deal is going "slower than expected." That said, I have heard nothing to indicate that the deal could unravel.

Second, as I have discussed in the NY Times and in my luxury tax piece, the luxury tax under the old deal likely caused a lot of dissension among low- and high-spending owners. That dissension may have eroded David Stern's bargaining position. I would not be surprised if the union reached out to high-spending owners during this negotiation process, since if the luxury taxes are distributed evenly, high-spending owners were big winners in this deal.

In addition, because of the loss of revenue in the 1998-99 lockout, the players' share of revenue skyrocketed to around 65 percent during the first few years of that deal. The owners may have been apprehensive about a repeat of that worst case scenario. In contrast, fewer than half of the NBA players were around for the last lockout so the repurcussions of a lockout may not have scared them as much.

All of this leads to a second question. How come we do not know how the luxury taxes will be distributed, especially since this seems to be such a critical issue?

I am bewildered by this. How luxury (and escrow) taxes are distributed is critical to the bottom line and decision-making of teams. Without knowing the distribution formula, teams do not know the costs of signing free agents or making trades. And my impression is that they are not banging down doors to find out. This suggests that teams either like uncertainty or are still struggling with understanding the full implications of the luxury/escrow tax system. I find both explanations implausible and figure that there has to be something else that explains this behavior. But figuring out what this "something else" is is beyond this writer's mental capacities.

Last updated: 9:00 PM, July 22, 2005

3 Comments:

Anonymous Dunkenstein said...

You talk about the players "making out like bandits" in the deal. But what about the high-spending owners. Not only are they now going to get escrow tax money (and some luxury tax money--you and I disagree on how LT money will be distributed), but they get to lower their luxury tax payments as a result of the "amnesty" program.

BTW I heard today that after hearing about the "amnesty" provision, Brian Grant stopped rehabbing at the Lakers facility in El Segundo, packed his bags and left town. He obviously saw the hand writing on the wall.

If there are losers, it's the owners who in the past religiously stayed under the Luxury Tax threshold. Two years ago, I believe they got $17M checks in luxury and escrow distributions. Next year, they'll probably get half of that amount. That's a significant hit on the old P & L statement.

Regarding distribution of Luxury Tax money, you have heard that it will be divided evenly and I heard that only the teams under the threshold will get 1/30 of the LT money and the rest will be distributed at the discretion of the league. My way would be similar to the last CBA where the teams under the threshold got 1/29 of the LT money and then the surplus was divided evenly among all the teams. We'll find out who's correct on July 22 (or later as codifying the agreement seems to be going slower than anticipated).

7/06/2005 4:04 PM  
Anonymous GrandAdmiralDan said...

First of all, excellent analysis Dan. I don't know what we'd do without you and Larry :)

I do have to concur with dunkenstein on his first point though. The players certainly made out like bandits here, but I am almost more bothered by all the "goodies" specifically geared towards the higher spending teams. I think the amnesty provision is absolute garbage. There is no reason for it at all. All it does is take additional luxury tax money that would have gone to more fiscally responsible teams and returns it to fiscally irresponsible teams despite the fact that the "mistakes" they correct under amnesty were made when they should have been under the assumption that they would have to pay luxury tax.

And I don't understand why the tax distribution system had to be changed either. It seems like there were really three sides to these negotiations:

1) NBPA
2) Lakers, Knicks, Dallas, Portland, etc.
3) The more fiscally "sane" NBA teams

7/07/2005 12:07 PM  
Blogger Dub V.2 said...

I broke my abacus.

7/08/2005 5:59 AM  

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