Are Long Term Contracts a Luxury Tax?

Although the team has begun to turn things around in the last few days, Red Sox fans cannot be very happy about how their team has begun the season. Going into the season the Red Sox were viewed by many as being the favorite to win the World Series, but their slow start has probably begun to make some of their fans nervous. One of the major reasons for the Red Sox slow start has been that Carl Crawford, a free agent signed by the Red Sox over the winter, has been playing very poorly. In his first 14 games, Crawford is hitting .149/.186/.179, numbers so low that they are almost not believable. There is something uniquely frustrating about a big free agent having such an agonizingly slow start. Nonetheless, most serious fans realize that the Red Sox are not going to play .353 baseball all season, and that by the end of the season Crawford will have numbers that are far better than what he has done so far.

Red Sox fans should not worry too much about Crawford this year or next, but should probably be more concerned about the back end of Crawford’s contract. Crawford, of course, was one of two big additions to the Red Sox offense last winter. The other was first baseman Adrian Gonzalez who came over from the San Diego Padres in a trade and recently signed a seven year contract extension. The Red Sox have secured Gonzalez and Crawford for the rest of their productive years and perhaps a little bit beyond that. This means that in 2016 and 2017 the Red Sox will be paying more than $40 million for these players during their 34 and 35 year old season. While it is possible that these players will both still be contributing at those ages, it is also certain that there will be several cheaper and better options available at left field and first base.

The Red Sox should not be faulted for pursuing and signing Crawford and Gonzalez to these contracts. Most teams with similarly deep resources would have been very happy to have added these two players during the off-season. Moreover, the Crawford and Gonzalez contracts are far from the most onerous long term deals in baseball. The Alex Rodriguez and Ryan Howard contracts are better candidates for that honor.

The bigger market teams like the Red Sox, Phillies and Dodgers can afford to sign players to big multi-year contracts knowing that they will be overpaying for these players by the end of their contracts, if they believe they can get a few excellent years out of these players during their first years with the team. No team does this more than the Yankees who frequently seem to have a few players on the unproductive end of long term contracts. In 2016, for example, the Yankees will owe more than $42 million in combined salary to a 36 year old Mark Teixeira and a 40 year old Alex Rodriguez.

Long term contracts are unavoidable for big market teams, because in baseball teams still pay for past performance leading players and their agents to still be able to demand long term contracts. In practice this amounts to something of a luxury tax all but guaranteeing that big market teams will overpay for players during the last years of their big contracts. Adding big contracts every year is the cost of trying to compete every season. This tax pushes money to the players and not to the lower payroll teams, but it can be punitive nonetheless. For example, while most small market teams probably wish they could have afforded Rodriguez during his first years with the Yankees, very few will want him during the years 2013-2017 when the Yankees will be paying him more than $110 million while he is in his late thirties and early forties.

Although this informal luxury tax does not send money directly to small market teams, it suggests a strategy which these teams can use to exploit the situation. Small and medium market teams should be particularly wary of long term free agent contracts because they cannot afford to carry overpaid 36 year old players in their decline years, but if these teams pick their spots well, many can compete for top free agents by offering slightly less overall money for significantly fewer years. For example, a top player seeking a seven year $140 million deal, might settle for $75 million over three years or even $120 over five years. The small market team might be overpaying slightly for the player’s top years, but would not have to pay for the decline years. The player would need to sign for another team after the initial contract expired, but given how much he would have made in the first part of the contract, it is possible that he would end up with even more than $140 million for the total period.

The corollary to this is that small and medium market teams should avoid long term contracts for free agents who are already in their late 20s or early 30s and probably only extend long term contracts to their own players while they are still relatively young. The Yankees, Red Sox or Phillies will not be happy about the Rodriquez, Crawford or Howard contracts in 2016 or so, but these contracts will not cripple their chances to compete. Similarly sized contracts for players in their decline years would have a much more devastating effect on teams like the Cleveland Indians, Toronto Blue Jays or Houston Astros.

Baseball’s economic arrangements still undoubtedly favor the wealthier teams who play in bigger markets, but as any fan in San Francisco, Tampa or a number of other medium sized markets where teams have had success in recent years knows, these advantages are real but not insurmountable. For years bigger market teams have had an advantage because they can afford to make mistakes, but having declining stars under large contract is not so much a mistake as it is a tax or cost of doing business for teams like the Yankees or Red Sox; and it is exploitable by other teams.