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Abstract
This paper presents a model of a professional sports league and analyzes the effect of luxury taxes on competitive balance, club profits, and social welfare. It shows that a luxury tax increases aggregate salary payments in the league and produces a more balanced league. Moreover, a higher tax rate increases the profits of large-market clubs, whereas the profits of small-market clubs only increase if the tax rate is not set inadequately high. Finally, we show that social welfare increases with a luxury tax.
Keywords: sports league, luxury tax, social welfare, competitive balance
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Introduction
A "luxury tax," or competitive balance tax, is a surcharge on the aggregate payroll of a sports team that exceeds a predetermined limit set by the corresponding sports league. The luxury tax was essentially designed to slow the growth of salaries and to prevent large-market teams from signing all of the top players within a league. The money derived from this tax is distributed among the financially weaker teams. The luxury tax thus aims to create a more balanced league, because redistribution among clubs counteracts financial imbalances.
In North America, the National Basketball Association (NBA) and Major League Baseball (MLB) operate with a luxury tax system. In 1984, the NBA became the first league to introduce salary cap provisions.1 The NBA's salary cap is a so-called "soft cap," meaning that there are several exceptions that allow teams to exceed the salary cap in order to sign players. These exceptions are mainly designed to enable teams to retain popular players. In 1999, the NBA also introduced a luxury tax system for those teams with an average team payroll exceeding the salary cap by a predefined amount. These teams have to pay a 100% tax to the league for each dollar their payroll exceeds the tax level.
The first luxury tax in professional sports was introduced in 1996 by MLB as part of its Collective Bargaining Agreement (CBA). This agreement imposed a luxury tax of 35% for the first two years and 34% for the third year on the teams with the top five payrolls during the 1997, 1998, and 1999 seasons. Between 2000 and 2002, the luxury tax system was replaced by a revenue-sharing system. MLB...