Baseball Therapy: Let’s Talk About Tax Policy

We have a lot of problems in the United States, and every few years, we get to hear a bunch of people blather on about what those problems are, what causes them, and how to best fix them before the very order of things that we know falls apart. We know of course that most people don’t pay attention to these issues until after the World Series is over (or so the saying goes), but this really is an opportunity to make the American Past Time great again. So on this Super Tuesday, I think it’s time we had a discussion about tax policy.

It’s CBA negotiating season in baseball, a time when the players and owners get together to figure out how they’re going to live with each other over the next few years (and how they’re going to split the money). But it’s also a time to figure out how to solve some of the pathologies around the game. I can think of three that will need fixing in this next iteration of the CBA.

• The Ian Desmond Problem. (Late update: no longer a problem.) Formerly known as the Kendrys Morales Problem. Formerly known as the Kyle Lohse Problem. The qualifying offer system probably could do for some tweaks to the number that “qualifies.” Ian Desmond, a perfectly reasonable option for a team who needs a shortstop, was on the sidelines until two days ago, because while there are teams that would have done great great to have an Ian Desmond on their team, they didn’t like him enough to give up a first-round pick.
• The Extreme Makeover, Baseball Edition Problem. Formerly known as “Rebuilding.” Sometimes known as… are we allowed to use the T-word here? The National League has become a two-class system in which some teams have decided to go for it and some have decided to… not. It used to be that this sort of thing would happen, not by design, but because a team just sorta fell into it. Now, we’ve entered the world where if you’re going to suck, you might as well suck loudly, lose 100 games and take a shot at that lovely first-pick-in-the-draft bonus pool.
• The “Dodgers Are Signing All of the International Free Agents” Problem. Formerly known as the “Yankees Are Signing All of the International Free Agents” Problem. In theory, this was supposed to be fixed by the introduction of signing bonus pools and the introduction of penalties for exceeding the bonus pool. The Dodgers, for having blown past the bonus pool allotment, now face severe restrictions on their signing activities for the next two years, and have had to pay a 100 percent tax on their expenditures above their signing bonus pool. Apparently it didn’t work. The Dodgers (and several other teams, to be fair) have simply responded to the two-year ban by buying about five years’ worth of players and have shrugged at the extra cost.

There’s an easily identifiable thread that runs through all three problems (or strategies, if you prefer): the ability to acquire young talent, either through the draft or through the international market. They tie back in different ways, but there’s one truth that is at the base of all of it. Baseball has a really poorly designed system for procuring new talent. Baseball has an orders-of-magnitude problem.

Or maybe baseball has what might be considered a political problem, one that they’ve never really solved. Let’s talk about extreme political ideologies. Baseball could choose – if it wanted to – to go to one extreme and become an entirely free market system. Everyone would be a free agent, in the broad sense of the word, and there would be no spending caps on anyone. Of course, this set-up favors those who already have boatloads of money. The rich teams could simply outspend everyone, and while no, money doesn’t guarantee success, it sure can fix a lot of mistakes. They’d probably end up with a system that looks a lot like what English soccer was for a decade or so with the four richest teams (Arsenal, Chelsea, Liverpool, and Manchester United) taking the top four places in the league in just about every season.

On the other side, baseball could – if it wanted to – implement a salary cap (and probably a floor as well) and pass out draft picks on a worst-to-first basis, like the NFL. It might not solve the problem of the same five teams going to the Super Bowl every year, but it at least makes it so that money isn’t the determining factor.

Baseball has tried to forge a path in the middle. There’s nothing wrong with trying to shoot for the middle, but it requires a well-designed system. Recall that free agency in baseball is a relatively new invention. (Those gauzy memories of the halcyon days when players went into the Hall of Fame having played for only one team are mostly the result of the reserve clause. Those players had little choice.) Baseball has allowed essentially unlimited spending in free agency (up until the institution of the “luxury tax” a few years ago, more on that in a minute) but has set up several carve-out programs that give subsidies to the teams having the hardest time.

· Free agency doesn’t happen until a player has reached six years of service time, and in the pre-arbitration period, a team can keep a player for what is widely acknowledged to be a discount. Teams that are able to bring talent up through their farm system benefit from getting talent at a discount rate.

· Draft picks and draft and international signing bonus pools are bigger for teams who have losing records.

· There’s a “Competitive Balance” draft lottery process that awards extra picks and dollars in the draft.

· The qualifying offer system (and its predecessors – remember “Type A” free agents?) is essentially a poacher’s penalty for teams – presumably rich teams – that outbid another team for “their” free agent. However, the bottom 10 teams are protected from the full brunt of that penalty in that they don’t lose their first round pick.

· Even waiver claims go in reverse order of the standings.

All of these are at least on the surface reasonable ideas for ensuring competitive balance without resorting to a salary cap or taking away free agency. But the problem is that they provide incentives not just for being a losing team, but for being the biggest loser. If baseball wants to continue to be a mostly capitalist system with some social welfare programs thrown in, that’s fine, but it’s going to have to do a better job designing its programs so that it doesn’t get the problems we’ve mentioned.

Consider that there are two basic ways in which a baseball team can find talent. They can either buy it on the free agent market or they can raise it on their own farm. (They can also trade for it, but that’s a separate category.) At this point, the cost of a win on the free agent market is now somewhere around $8 million. In 2013, I estimated that the cost of a cost-controlled win – on average – was about $2.7 million, less than half of what it costs on the free agent market. I got those numbers from adding together the average team’s draft and international pool bonus slots, the amount of money they paid to players in their cost-controlled years, and a decent estimate (based on what I learned from a couple of “friends”) of what a team typically spends on its player development system, between paying coaches, minor-league salaries, and all the stuff that goes along with it. The rest was dividing by the number of wins that pre-arb players produced. It doesn’t work on a player-to-player basis, but in the aggregate, it works great.

This is the order of magnitude problem. Pre-arb wins are less than half the price of free agent wins, so they represent a gigantic bargain. Particularly for teams that are already on the wrong end of the win curve, it’s a no-brainer to put money here. Going from a 70- to a 75-win team will cost you millions and won’t get you any meaningfully closer to the playoffs. And a good chunk of your access to that oasis is based on being as bad as you can be. And on the flip side, the price for picking up the sort of free agent that might get you closer to 75 wins (or even 81 wins) will cost you a first round pick… and the money that goes with it.

So, how to fix each of the problems?

The Ian Desmond problem seems like the easiest to fix. There is the dangling issue of how good a player should be before he deserves being compensated for, although that’s a bit of a matter of aesthetics. But realistically, there will always be a player on the cusp of “good enough to sign, but not worth giving up the first rounder.” The idea behind a team losing the first rounder was that it was a direct tax from the team signing the player to the team that had been wronged by signing him. If baseball is intent on compensating teams for the loss of free agents, but wants to avoid the Ian Desmond situation, they may have to re-think the design of the tax. One idea that’s been floated is that the team losing the free agent might be entitled to an extra first-round pick (and presumably some extra bonus pool money), but that the signing team wouldn’t lose its pick. Perhaps the team losing the free agent would get the pick directly in front of the signing team (i.e., if the signing team was picking no. 22, the team losing the free agent would pick 22^nd and the signing team would be pushed to no. 23… also, everyone behind them would be bumped down a slot).

The signing team doesn’t lose as much and so is less tempted to shy away from signing Ian Desmond. They get to keep the draft pick and really only get bumped back one slot, and maybe we even make the bonus slot that the team picks up equal to the signing team’s but don’t penalize the signing team. To show a real example of how this might work, let’s look at what happened when the Tigers signed qualifying offer recipient Justin Upton. (I couldn’t find the actual bonus slots for 2016, so the slot numbers in here are 2015 values).

* – actually, the Royals gave up their pick for signing Ian Kennedy. Funny enough, the Padres got that one too. Just ignore that for the moment.

In the new system, it would look more like this

In the first scenario (the current way of doing things), the Royals and the Cardinals are essentially unaffected by the Tigers' signing of Justin Upton and the Padres receiving a compensatory pick. In the second, the Royals haven’t lost any money in real terms, nor have the Cardinals, but the Royals have one more team in front of them who might grab that shiny high schooler that they want. And in the closed ecosystem of the draft, new money has been created and added to the pool. While the amount in real terms hasn’t changed, the Cardinals and Royals used to control a certain percentage of the money floating around and now they control somewhat less of it. Not by much, mind you, but they had nothing to do at all to with the signing. Why are they being affected?

What we’ve really done to create some inflation that acts as a “tax” on everyone else. It pays for the Tigers to be more free to sign Justin Upton and pays for the compensation to the Padres to keep competitive balance. It penalizes everyone else a little bit. Players would like it because it frees more teams up to be in the bidding (read: $$$). Teams might balk at the idea of being penalized, but there will come a time when the shoe is on the other foot, and they too will be glad that they don’t have to bear the full brunt of signing a free agent. Small-market teams, in particular, so wedded to the seed corn that is a first-round pick, would seem to get a special benefit and might suddenly find themselves better able to stretch themselves out a bit to go after that one missing piece for a championship run. By sharing the burden, and turning free agent compensation into an inflationary pseudo-tax rather than a peer-to-peer penalty, Ian Desmond might just be able to sign with the Rangers to play left field a little earlier in the offseason and not on a lifeboat contract.

As for the tanking problem, it seems that one of the issues is that at the top of the draft pool (and the bottom of the standings) there’s a yuge discrepancy as to who gets what. Looking again at the 2015 draft slots, we see that last year’s top drafting team, the Arizona Diamondbacks, got $8.6 million in pool money for the first pick. The tenth team picking (the Phillies) got $3.2 million. It’s not hard to see why teams would be incentivized to run to the bottom of the table. It’s worth asking why the discrepancy is there to begin with. There’s a cultural expectation that the 1-1 player should get more than the second pick, and while I get why it exists, it’s incentivizing some very bad behavior.

I suggest that there should be a minimum number of wins, perhaps 72, and teams below it got no extra bonus pool cash allotted. The occasional 53-109 team might complain bitterly that they are in much more dire shape than the 65-97 team, but frankly, both teams basically need to replace most of the 25 players on their rosters. There’s no qualitative difference between them, so it makes no sense to reward the one that took steps to be extra-super-duper-schmooper bad. The amount of money in the overall pool could stay the same, but all teams below the minimum in wins would be given the same pool size. Or if we insist on keeping the structure of having the first pick be worth sooooo much more, the occasionally talked about lottery among the bad teams would make sense here. Since in reality, they’re all the same in terms of their needs, let some ping-pong balls, rather than a race to the bottom, decide whether they get the extra money. While it’s a fact of life that some team’s front office will eventually be looking at their roster and see a 90-loss season ahead, we shouldn’t incentivize them to go for 100.

But now the problem of the international market. This was supposed to be “fixed” by the 100 percent surcharge on international signings that went over and above a team’s bonus pool allotment, plus the two-year ban on signing any big ticket free agents. The problem is that teams probably did the #GoryMath and realized that if cost-controlled talent produced wins at a rate that was 2.5 to 3 times cheaper than free agents (and that those are really the only two ways to get talent on your team), even making things twice as expensive wasn’t going to deter anyone from running over their limit. The two-year ban meant that teams just bought in bulk when they were eligible to shop.

I think it’s also informative that there is a major-league payroll “luxury tax” that can be rather hefty, and you often hear stories about teams on the high end of the payroll spectrum fighting to stay underneath the threshold for that tax. One reason might just be the raw magnitude of the penalty (the Dodgers paid $43.6 million in luxury tax last year), compared to the penalty for exceeding the international signing tax rate.

But aside from dollars-per-win concerns, there are a couple of qualitative differences that make flouting the international signing bonus pools even more appealing. Triggering the luxury tax is most likely the result of signing a small number of high-dollar free agent contracts. We’re talking about a small number of players who may or may not perform up to expectations or even stay healthy. If one of them falls apart, it can torpedo a team’s entire season. The fact that he’s a free agent means that he’s probably on the wrong side of 30, meaning that it’s more likely that he’ll get worse than better. Triggering the tax on international free agents happens through signing a large number of young players. If one of them falls apart, he’s one in a class of 40 and they’re all fighting through the minor leagues anyway for 25 roster spots. They are younger players, so any surprises are more likely to be in the “he got a lot better than we thought he’d be” direction than the other way.

Still, we’re likely to hear that the international free agent surcharge system “didn’t work.” I’d argue that the problem isn’t that the tax didn’t work, it’s that it’s not high enough to bring the cost of a win in line with free agency. My initial analyses from 2.5 years ago looked at all cost-controlled players, whether obtained through the draft or through the international market. It’s possible that the two produce different rates of return, but essentially, whatever the rate of return is on international free agents compared to “been in the league six years” free agents, the surcharge basically has to equate those two prices. (Or the international free agents need to start asking for more…) Elsewise, teams have every incentive to just spend on the international market, no matter what the silly pool number happens to be. Here’s one place where a tax increase needs to happen.

Right now, the signing pools function as tax exemptions, and they can be used to promote competitive balance with the bad teams getting a little extra pool money (although again, I’d put a maximum number of losses on those awards too) to shop with tax-free, but if you want to solve – or at least minimize — the “Dodgers sign everyone” problem, it’s a simple matter of math. Smart teams will spend their money where it will do the most good. If baseball wants to incentivize teams to build from the amateur ranks upward and give a little boost to the teams who have fallen behind, it needs to close up the loophole that allows the big, successful teams to eat that seed corn.

Baseball’s going to have some fun decisions to make in the next CBA. If it wants to continue to be a place where the free market still churns out some good contracts for the players, but there’s still enough room for an enterprising small market team to have some room to work with within the rules, then it needs to pay very careful attention to its orders of magnitude problems and to design its support structures accordingly. Otherwise, we’re due in for more of some rather unsightly behaviors that follow from not paying close attention to them.