How NBA's Luxury Tax Penalties Will Impact Elite Teams

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How NBA's Luxury Tax Penalties Will Impact Elite Teams
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The Miami Heat

The clock is ticking on the NBA’s era of the constructive, $1 dollar for $1 dollar luxury tax.

But looking ahead, it’s important to know how the NBA’s luxury tax penalties will impact elite teams.

In short, we can say with 100 percent certainty that all teams will reinspect their business models in an attempt to avoid becoming a perennial tax team. That is, of course, unless the owner is deep-pocketed and the team is a perennial title contender.

By now, most NBA fans are aware of the fact that the league and the NBA Players Association agreed on a new tax system that will take effect beginning with the 2013-14 season.

Since the luxury tax was introduced in the 1999 collective bargaining agreement, the league has levied a dollar-for-dollar tax against the teams that exceeded the tax threshold. But what we saw over time was that small markets were often reluctant to find themselves above the tax threshold because a $10 million tax payment, for example, would be difficult for a team such as the Milwaukee Bucks or San Antonio Spurs to stomach.

But big-market teams such as the New York Knicks and Los Angeles Lakers—by trading players and using cap exceptions—routinely amassed nine figure payrolls and scoffed at the notion of curbed spending.

The result has been big-market teams outspending small-market teams and, in the eyes of the NBA, threatening a long-term system in which competitive balance between small markets and big markets is sustainable.

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Adam Silver (L) and David Stern (R)

That’s why, prior to the 2011 lockout, the owners initially sought a system with a $45 million hard cap. When that was rejected, they eventually offer the players a “flex cap” system that allowed some exceptions, but still had an absolute salary ceiling that teams could not exceed.

It was all about curbing spending.

Neither of those proposals were acceptable to the NBPA. Ideally, the NBA wanted its new system to prohibit teams from spending through the roof. That, though, is something that the NBPA would never agree to, so the league did the second-best thing: it made consistently exceeding the luxury tax threshold prohibitively expensive.

Today, the tax rates are much higher and the repeater tax rate is so expensive, it’d make even the Brooklyn Nets' Mikhail Prokhorov cringe. And moving forward, we'll see even the NBA's elite attempting to avoid the tax.

Instead of a dollar for dollar tax, a team that has a payroll that exceeds the luxury tax threshold will pay based on a sliding scale that gets more expensive the higher they are over the threshold.

The new tax rules are very complicated but to keep things somewhat simple, look at the Lakers.

This season, the tax threshold is $70.3 million. The Lakers payroll is just about $100 million, meaning that it is about $30 million over the tax threshold.

Under the old dollar for dollar tax rules, the Lakers would have to write a $30 million check to the NBA to cover its luxury tax bill. And while $30 million is a lot, in this era, we’ve seen teams have payrolls exceeding nine figures, and we’ve seen teams—such as the Knicks and Mavericks—write even more expensive checks.

And for the Lakers and their multi-billion dollar TV deal, $30 million is lunch money.

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Dwight Howard

But under the new rules set to take effect next season, if the Lakers payroll exceeds $100 million by the time the 2013-14 season ends, instead of being charged a more manageable $30 million, the Lakers tax bill would be a whopping $85 million.

The new tax rate is a sliding scale that charges a team a higher rate for each additional $5 million it exceeds the tax rate.

For the first $5 million a team exceeds the tax threshold, it will be charged $1.50 per dollar, meaning that the cost of exceeding the tax threshold by $5 million is a tax charge of $7.5 million.

For each dollar between $5 million and $10 million that a team exceeds the tax threshold, it will be charged $1.75 per dollar, so a team that is $9 million over the tax threshold would pay $7.5 million for the first $5 million, plus an additional $6 million for the next $4 million.

In short, the tax has become much more expensive and much more oppressive, and while a team exceeding the tax threshold by $30 million will probably cease to be the norm, a team exceeding it by $15 million would be hit with a tax bill of about $29 million. That’s more reasonable, but still a hefty sum.

And not exceeding the tax threshold by more than $15 million will require astute management and making tough decisions. We are much less likely to see teams taking eight figure risks on young players based solely on upside.

That's true even before taking into account the notorious “repeater rate” luxury tax charges. The repeater rate essentially discourages teams from being perennial taxpayers. If a team’s payroll exceeds the luxury tax threshold three times during a four-year period, it will have to pay an additional $1 on the aforementioned sliding scale.

So, for example, instead of being charged $1.25 per dollar between $0 and $5 million over the threshold, the charge is $2.50 per dollar. And for each dollar between $5 million and $10 million, the repeater rate is $2.75 as opposed to $1.75. For each dollar between $10 million and $15 million, instead of being charged $2.50 per dollar (under normal circumstances), the charge is $3.50 per dollar.

In other words, if a team makes exceeding the tax threshold a habit and is charged the repeater rate after being a taxpaying team four times in any five year period, its tax bill would see a substantial increase.

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Mark Cuban Cares About The Tax

A team that has a payroll exceeding the tax threshold by $15 million and paying the repeater rate would be hit with a tax bill of an astonishing $44 million.

If these numbers seem ridiculously high, it’s because they are.

One of the NBA’s major concerns with the 2011 collective bargaining agreement was to make widespread changes to the NBA’s economic system that would discourage teams from hoarding talent and help facilitate player movement.

If it were totally up to the league, four Hall of Famers being on one roster would be a thing of the past. But since the NBA can’t make a hard rule that prohibits something like that, it did the next best thing. It made it prohibitively expensive to field and pay for a team featuring that much talent.

In the future, the only way we’ll see teams with a “Big 3” or a “Big 4” will be if some of all of the star power is willing to make some major concessions with regard to the money they are to be paid. Moving forward, it’s going to be quite expensive to field a team with three maximum salaried players, because doing so almost ensures that—once draft picks, cap exceptions and the like are used to fill out the rest of the roster—a team will certainly be a taxpayer.

And again, making a habit of being a tax payer will result in being subjected to the repeater tax rate.

The San Antonio Spurs have been able to keep their core intact mainly because Tony Parker and Manu Ginobili have both been willing to accept less than maximum money and help the team stay below the tax threshold.

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Serge Ibaka

But moving forward, we will see situations like James Harden and the Oklahoma City Thunder with a bit more frequency. After paying Kevin Durant and Russell Westbrook maximum money and making a substantial investment in Serge Ibaka, the Thunder knew that paying Harden even a four-year maximum deal would ensure it’s place as a tax team for the foreseeable future. And becoming a repeat tax offender would be a virtual certainty.

For just the foursome of Durant, Westbrook, Ibaka and Harden, the Thunder would have paid $59.3 million, $62.9 million and $65.9 million for the 2013-14, 2014-15 and 2015-16 seasons, respectively.

Dedicating that much of a payroll to three or four players ensures a team’s place as a taxpayer and with the new oppressive tax system on the horizon, it’s something a lot of NBA teams will seek to avoid.

So as we consider what will become of the Miami Heat with LeBron James, Dwyane Wade and Chris Bosh and the Lakers with Kobe Bryant, Pau Gasol and Dwight Howard, don’t be surprised if at least one of the aforementioned six find themselves with a new zip code over the next few years.

The Brooklyn Nets, New York Knicks and Los Angeles Clippers could all find themselves in similar predicaments, though all owners involved have deep pockets are may be willing to become perennial tax teams.

But as for what happened with the Thunder and Harden, that was a situation that was all about finances and fear of the luxury tax. Younger teams such as the Portland Trailblazers, Denver Nuggets, Chicago Bulls and even the Philadelphia 76ers will have to think long and hard about not only retaining some of their young free agents, but also how much they will pay them.

In the NBA’s previous economic era, re-signing a young player with promise to a rich deal was a no-brainer. But today, throwing eight-figure annual salaries at a fringe player that can’t single-handedly get your team to the playoffs is a very risky and perhaps very expensive proposition.

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Brandon Jennings

This summer, with the likes of Brandon Jennings and Tyreke Evans hitting the market, likely as restricted free agents, and Al Jefferson, Paul Millsap and J.J. Hickson hitting the market as unrestricted free agents, it’ll be interesting to see where they end up and how much they’re paid.

Moving forward, don’t be surprised if we see situations such as the one that occurred with Harden and the Thunder occur more often.

Entering play on Dec. 26, the Houston Rockets are 15-12 and, behind Harden and Jeremy Lin, seem to be coming together. Both Harden and Lin were attained by the Rockets due in part to their incumbent teams—the Thunder and Knicks—considering the luxury tax implications of retaining them and paying them their market value.

Fiscal restraint. It’s here in today’s NBA, and it’ll likely become a widespread phenomenon that will ultimately foster player movement and help competitive balance across the league.

Somewhere, as he counts down the days until the end of his tenure, David Stern is smiling.

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