Explainer: the NBA luxury tax and how it perpetuates Golden State’s dominance

Betting
Fri 8th March 2019

All NBA franchises operate within a salary
cap, so how is it that the Golden State Warriors, and other huge franchises
like the Knicks or Lakers, always appear to have more money available to sign
free agents to enormous contracts?


 

The NBA employs what is known as a “soft salary cap” – “soft” because, unlike most other
professional sporting leagues in America, teams are not necessarily forbidden from exceeding the limit set by the cap.


 

In the NHL and NFL, for example, there are
almost no (if any at all) circumstances under which a team is allowed to exceed
the cap  


 

The salary cap limit for each season in the
NBA is essentially (and in simple enough terms for the purposes of this article)
calculated as a percentage of whatever revenue the league generates from the
previous season.


 

For example, at the end of last season, the
league announced the salary cap for the 2018-19 season
would be set at $101.869 million.


 

In 2011 the NBA (represented by the then commissioner
David Stern and all 30 team owners) signed a Collective Bargaining Agreement (‘CBA’)
with the NBA Players Association, ending the infamous 2011 lockout.


 

The CBA codified some crucial salary
cap conditions, such as the percentage of revenue the players would receive each
season – down to close to 50% after being as high as 57%.


 

However, the most significant event to arise
out of the CBA was the reinforcement of a rule which had existed for
some time – the oft-quoted, rarely understood, “luxury tax”.


 

What is the luxury tax?

The NBA’s salary cap is subject to certain exceptions
allowing teams to exceed the cap in certain, specific circumstances. These exceptions are
too numerous and intricate to list here, but in order to understand the luxury
tax it is enough to know that it is easy enough for teams to legitimately and regularly exceed the $101.869 million cap.


 

However, at a certain threshold, teams
begin to be penalised for exceeding the cap by too much, even when that excessive spending has been done
legitimately.


 

This is known as the luxury tax threshold.
In 2018/19 that threshold has been set at
$123.733 million. This gives franchises almost
$22 million over the salary cap to play with before they begin to be penalised by
the luxury tax.



 

Luxury tax before the CBA

Prior to 2011 the luxury tax had existed,
but only as a dollar-for-dollar tax on every piece of a team’s
spending which exceeded the luxury tax threshold. For example, spending $1
million over the threshold would lead to an owner paying the NBA $1 million in
luxury tax.


 

In practicality this led to teams with rich
owners (e.g. the late 2000s Dallas Mavericks under Mark Cuban) spending as much money
as was needed to sign any player they wanted. It meant very little to owners with
staggering personal fortunes to spend double the cost to add a player if it meant a
higher chance of winning, and thus a greater chance of recouping revenue through
jersey sales, ticket sales, sponsorship etc.


 

Effectively, prior to 2011, the luxury tax
acted as an incentive for the rich teams to get richer, whilst small or mid-market
teams, with owners reticent to spend too much money, suffered.


 

Luxury tax after the CBA

There were two key ways in which the 2011
reforms strengthened the luxury tax to the point where it could offer a genuine
deterrent to owners looking to throw cash around, and thus move towards providing
a level playing field for smaller franchises.


 

Progressive tax rate

As mentioned previously, before 2011 any amount spent over the luxury tax threshold
would carry a 100% tax – i.e. spending $50 million over the threshold would mean you had
to pay an extra $50 million to the league. In practice this offered little
deterrent for owners to spend enormous amounts in search of a championship win.


 

The 2011 CBA introduced a progressive tax
rate. Effectively, the more a team spends over the threshold the more they are now
forced to pay in tax.


 

That progressive rate stands at:

·      150% for spending up to $5
million over the threshold

·      175% for $5-10 million

·      250% for $10-15 million

·      325% for $15-20 million

·      375% for $20-25 million

Etc.

                                                                                                                           

So, a team that spends $22 million over the
threshold pays:


$7.5 million ($5 million x 150%) + $8.75
million ($5 million x 175%) + $12.5 million ($5 million x 250%) + $16.25
million ($5 million x 325%) + $6.5 million ($2 million x 375%)


 

= $51 million in luxury tax.


 

That is $29 million more than they would have
paid prior to 2011.


 

Repeater tax

The second way the 2011 CBA increased the
power of the luxury tax was through the introduction of a repeater tax.


 

The progressive rates can be increased even
further if a team earns classification as a repeat offender.


 

“Repeat offenders”, for the purpose of the
luxury tax, are those who have paid the tax in three of the preceding four
seasons.


 

Repeat offenders are subject to the
following progressive tax rates:




·      250% for spending up to $5 million over the threshold

·      275% for $5-10 million

·      350% for $10-15 million

·      425% for $15-20 million

·      475% for $20-25 million



Etc.


This means a repeat offender
spending $16 million over the threshold pays:


$12.5 million ($5 million
x 250%) + $13.75 million ($5 million x 275%) + $17.5 million ($5 million x
350%) + $4.25 million ($1 million x 425%)


 

= $48 million in
luxury tax.


 

That is $32 million more
than they would have paid prior to 2011.


 

How does the luxury tax work in
practice?

Clearly, owners are
required to be more prudent with how they spend their money. This doesn’t
stop certain franchises with cash-rich ownership from continuing to splash the cash in search of championships.


 

For example, in 2017/18
the Cleveland Cavaliers paid $50.7 million in luxury tax in order to retain key
pieces of their roster around LeBron James. The Cavs were effectively pushed
$16 million over the luxury tax threshold by paying Tristan Thompson the $82
million contract required to keep him in free agency.


 

Only three other teams
the Warriors, Thunder and Wizards – paid the luxury tax in 2017/18, which is
perhaps a reflection of the league’s recognition of the continuing dominance of Cleveland and
Golden State. Why would mid-market teams, like, for example, the Utah Jazz,
pay the luxury tax if objectively they’re very little chance of making it to the NBA Finals?


 

The tax has huge
implications for teams, like Utah, who are looking to be competitive but also trying
desperately to stay under the threshold. The 2018/19 Houston Rockets are the
prime example of this in action. They currently sit smack bang on the edge of the luxury
tax threshold, using $122.988 million of the $123.733 million available to them. This offseason they
essentially had to choose between paying Trevor Ariza $15 million, which would have
resulted in going over the threshold and paying upwards of $28 million in
luxury tax, or letting Ariza go in free agency.


 

They had to let him
go. This is where the luxury tax, in theory, is most effective. Its objective
is to allow small-market teams (like Phoenix, where Ariza ended up on a $15
million contract) to attract stars when the bigger franchises can no longer
afford to keep them.


 

How are the Warriors maintaining their success?

Golden State are looking
at exceeding the luxury tax threshold (as a repeat offender) by over $21
million in 2018/19, which will result in a luxury tax bill of over $50 million.
This is mostly thanks to the cost of retaining Kevin Durant under a 2-year $60
million salary.


 

Arguably, the Warriors
are doing exactly the opposite of what the league wants the luxury tax to achieve.
They are consistently, wantonly, flaunting the entire premise of the NBA’s
salary cap by paying their free agents their market value, and retaining their All-Stars
year in, year out.


 

The logical question
is, how can they afford this amount of cash every year?


 

The simple answer is
that the Golden State Warriors are unlike any franchise the NBA has ever seen.


 

In 2010, businessman
Joe Lacob and a group of investors purchased the Warriors for $450 million.


 

9 years, 3 championships
and one of the greatest dynasties in NBA history later, the Warriors are worth
an estimated $3.5 BILLION (see below graph, thanks to 
www.statista.com).





 


In 2018 admission prices
at Oracle Arena were raised by 25%, and yet tickets have still sold out for very
home game in 2018/19. Stephen Curry has the most popular jersey in the NBA, and
Kevin Durant has the third – overall the Warriors easily top the list for most popular
merchandise. In 2017, they signed a 3-year, $60 million dollar jersey sponsor deal with Japanese e-commerce Company Rakuten. That deal is almost double the value
of the second-largest jersey arrangement in the NBA.


 

This is likely just a
small fraction of the endorsement money being brought in to the Bay Area. Therein
lies the answer. Success breeds money, which breeds more success and more
money.


 

The Warriors hit on
their championship nucleus (Curry, Thompson, Green, Iguodala) through shrewd drafting
and trading. 
In 2015 (the year they won their first championship) the Warriors were spending $4.244 million LESS than the luxury tax. They only began paying the tax in 2015/16, in order to keep Klay Thompson and Draymond Green. Thus, crucially, they had success and then they spent the money to maintain their success.


 

The converse strategy
is to spend the money before you have
success.
The risks are obvious – what happens when you spend money trying
to win, and then can’t?


 

The 2013/14 Brooklyn Nets
(among many other disasters this particular team has become famous for) perfectly
exemplify how badly this can backfire.


 

The 2013/14 NBA luxury
tax threshold was $71.748 million. The Nets had Joe Johnson, Deron Williams,
Paul Pierce, Brook Lopez and Kevin Garnett on horrendous contracts, leaving
them with $102.928 million in taxable salaries. Brooklyn had to pay, wait for
it, an extra $90.605 million in luxury
tax
as a result of exceeding the threshold by $31.180 million.






 

The Nets ended up
sneaking through the first round of the playoffs in 7 games as the 6 seed,
before getting dismantled by LeBron James and the Heat in the second round.


 

It’s fair to say that
the franchise has never properly recovered from this season.





Where to from here? 

Every NBA team is trying to emulate the Warriors, but the sheer volume and speed in
which their revenue increased over the space of less than a decade means it
will be nearly impossible for lightning to strike twice.


 

The Warriors can
continue to spend at a rate which other teams simply can’t compete with.


The paradox
is that to have a chance at success against the Warriors, other teams need to spend
at a comparable rate in order to attract players capable of success, but in order to spend at a comparable rate to the Warriors other teams first need to have success.


 

Make sense? It’s the ultimate catch
22.  


 

Golden State’s
finances are in as excellent shape as their 3-point shooting, and that means
both are likely to continue for the foreseeable future.




For more salary cap information on all NBA franchises, check out the brilliant website: www.spotrac.com/nba/cap

 

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