Incoming freight train: the NBA's repeater tax, and how to talk to Thunder critics about James Harden

Last week, SB Nation's Mark Deeks provided an insightful analysis and update on what has become known as the repeater tax. As we have written in the past, it is coming soon and has potentially crippling effects on teams who breach the tax threshold on a repeated basis.

Mark writes:

Next season, the repeater tax, which penalizes teams for being over the luxury tax for multiple seasons, comes into force. It is thought to be one of the toothiest new pieces of apparatus for revenue sharing and attempted market equality that the 2011 CBA has to offer. How toothy will it be?

Potentially, very.

Using the examples of the Brooklyn Nets and Chicago Bulls, Deeks outlines how each of these franchises are facing difficult decisions ahead. They can either face incrementally, exponentially staggering tax burdens, or they can shed part of their roster to avoid the fines. Deeks does a good job showing the kinds of options these two teams have. Two sticking points however due to the timing of his article:

1) The Nets, a chic pick before the season began because of how well they matched up against the Heat, are in freefall and show few signs of spinning out of it.

2) The Bulls are now without Derrick Rose for the rest of the season, putting them back in the very situation that caused them to pay the luxury tax a year ago.

There are two points I'd like to make about both these teams' situations and how it relates to a team like the Thunder and their dearly departed James Harden. This analysis is germane to the repeater tax, but hits more on the fundamental concept of going over the NBA's luxury tax threshold.

1) We will pay for certainty.

If you are familiar with investing, then you know that two of the most common investment vehicles are stocks and bonds. Who doesn't love stocks and bonds? Most people can tell you with reasonable precision the difference between a stock and a bond. Generally speaking, a stock carries with it more risk, but it offers greater reward. On the other hand, a bond reduces the potential reward for the sake of guaranteed return. For argument's sake, say that you have $1,000 to invest. If you are interested in preserving your capital, you buy the bond in order to lock in a guaranteed rate of return (called the coupon or interest rate). If you are interested in creating a greater rate of return but are not afraid of coming up a loser, then you would buy the stock, knowing that a) you might receive a dividend and b) the stock could appreciate, which can earn you a capital gain.

Which scenario costs more?

In both cases, you spend $1,000. However, in the case of the bond, you are intrinsically paying more because you are deciding to forgo the higher potential earnings that a stock might provide (but might not!) in order to receive the guaranteed return of the bond. You have paid, in the form of an opportunity cost, for the certainty of a rate of return.

Certainty costs something.

To relay this concept to the Nets and Bulls, they chose to pay a premium for certainty. They willfully paid more than they had to in order to guarantee a certain rate of return, which in basketball nomenclature is playoff wins. This is the argument that Thunder naysayers often bring up when the James Harden trade arises. Many critics have argued from all perches of the tree that by being unwilling to pay Harden a max contract (and by extension a tax penalty because it would have put OKC over the tax limit), they refused to pay the certainty equivalent. Vis a vis, the Thunder will never get back to the Finals, the window has closed, karma has Sam Presti in its death embrace, weeping and gnashing of teeth, etc.

There is of course a flaw in this analysis, and we Thunder fans need to look no further than the two teams that Deeks analyzes (and if you need to keep looking, teams from Boston and L.A. would be begrudgingly happy to comply).

The flaw is this - you cannot purchase certainty in the NBA.

The margin for error is simply too small, the competition to great, to make it possible to acquire certainty. I was sitting in the same room with the TNT guys when they brought up the Nets - claiming Brooklyn was built perfectly to take down the champion Heat. They had the size, the veteran leadership, and match-up advantages all over the court. "How do the Heat guard that?" they asked, incredulously. Brooklyn saw their opening, they took their shot, and willingly accepted the cost of the decision, to the applause of many. That's what it's all about when you're a wealthy NBA owner, right?

Well then...things have not gone exactly according to plan in Brooklyn.

The Nets are sitting at 3-10, which means conservatively, they are going to have to play .500 ball the rest of the way in order to sniff an 8 seed. This also means that their first round opponent is likely Miami or Indiana. If they overachieve and get up to a 5 or 6 seed, they'll get those two teams in the 2nd round. This is how Deeks describes the Nets' financial situation:

To put those numbers in a real context, we can use that most obvious example: the Brooklyn Nets and their tax number this season of $102,211,009 against a tax threshold of $71,748,000. Using the 2012-13 tax rates, they would have paid $102,211,009 in salary and $30,463,009 in luxury tax for a total expenditure of $132,674,018. Using this season's tax rates, though, they are due to pay the $102,211,009 in salary, but pay the tax at the various incremental rates. After some maths, this means a total tax bill of $87,199,293, for a total player payroll expenditure of $189,410,302.

Whew! How the Nets avoided the repeater tax

The Nets will NOT pay the repeater tax this season, thanks in part to a timely trade. Nets Daily has the details.

The Nets will pay all that money and will face the Heat or Pacers in the 2nd round. At best. This is the cost of certainty, and it is quickly becoming certain that the Nets have made a mistake of catastrophic proportions. The Bulls' situation has slightly less sticker shock, but the outcome is virtually the same. They will likely pay the tax (unless they decide to shed payroll) and their season's outcome is likely going to be identical to the one a year ago.

You cannot purchase certainty in the NBA.

2) How then do we discuss the repeater tax's potential impact on small market teams like the Thunder?

You have heard it. I have heard it. We all have heard it. The Thunder have obviously foregone repeated trips to the Finals by trading away James Harden. How can this trade possibly be defended?

To answer this question, I turned to Tim Donahue, the wise proprietor of the Pacers' site, 8 Points, 9 Seconds. Not only is he one of the few who can parse out this conversation effectively, but he also covers a team that is similar in many regards to the small market Thunder, right down to their championship aspirations and their team president Larry Bird's vow to never pay the luxury tax.

My question for Tim:

One hypothetical question I always struggle to address is when a critic of a team that lets a player walk because he's too expensive exclaims, "Why did they let him go? these guys are rich! They can pay the fine!"

How would you answer that question in a way that is both on point and helpful but not too snarky?

Tim's response:

It is a very difficult thing to answer without being either (a) overly analytical and descriptive or (b) overly blunt and snarky...consider these rough numbers:

(Per Tim's concession to me, this is a back of the envelope calculation, which is directionally correct but numbers may be variable- Sherman)

Average ticket price in Indiana was about $32 last year. That means a regular season sellout generates about $600k gross, and playoffs are probably around $900k (optimistically). Selling out 41 regular season games generates about $25mm, and 16 [potential] playoff games another $15mm. So, $40mm at current prices, with the possibility for that to maybe get to $50-55mm w/ best case price increases (and a title and lots of playoff games).

Add to that between $5-10mm local TV money, plus perhaps another $5-10mm in local other money (advertising, luxury suites, etc), Indianapolis is probably - at the absolute peak - a $75mm annual market, locally. More likely, it will hover around $60mm during the good years, and has dipped into the $30s in the last few lean years. This means that - given the cap levels - the Pacer payroll will already be greater than the locally-generated revenue.

Of course, then you get national TV money and revenue sharing, but you also have to keep in mind that some of that $60mm local gets kicked over to the league offices (probably about 10%, but that number is out of date), and then the Pacers have to run the front office, game nights, the Fever (breaking even-ish) and Pacers Sports & Entertainment - which manages the arena. Also, the bigger the local money, the less the revenue sharing, but it's not a one-for-one. Indy probably received about $20mm in net TV revenue sharing last year, but that will decline this year, hopefully more than offset by the increased revenue.

If, next year, Indy is faced with going into the tax to keep Lance Stephenson, it's going to be tough. The tax threshold is already about $6mm more than Indy's payroll this year. Let's say they go 2.5mm into the tax. That means Indy will add $8.5mm in salaries, plus $3.75 mm in taxes, increasing their costs by $12.3mm. Plus, they'll lose the tax distribution, which even the half share is bigger than the full share under the old plan. So, let's guess at $2.7mm, just to give us a nice $15mm.

So, that $15mm increase equates to all (or more) of the gate for a deep playoff run, or the equivalent gates of 20 to 25 regular season games.

Plus, the whole, "keep a title contender together for another chance," is a pretty thin argument. Too many moving parts, too much luck to believe that, "keeping this guy gets you a title." Actually, the case is more compelling if you've won a title. I think [Pacers owner] Herb Simon may go into the tax, a little, but I think chances go up if they were to win it all this year. It becomes a proven thing, and they can bank that type of success. The "just-missed" thought process is too risky for my taste, requiring too much speculation and banking on fans not playing a wait-and-see game early in the year.

To me, the Simons have shown the willingness to pay more than the market actually bears (locally), and the luxury tax threshold is a perfectly valid choking point for every market outside of NY, LA, CHI and maybe one or two others. I consider it to be somewhat unreasonable for fans - who foot very little of the actual bill (gate accounts for about 1/4 or less of total NBA revenues) - to expect most owners to pay the tax. My overwhelming impulse when someone says, "Pay the tax," is to ask them, "Great, how much more are you going to chip in?"

I think that going into the tax in small markets is a waste of money, and - worse - shows poor operational discipline. I actually think Presti and Bird are better off with a hard, "No," than with a, "Maybe." It limits them, but also gives them clear guidelines and allows him to play within a defined field. They have to take a longer view and be more diligent with their decisions, but I don't see that as a bad thing.

I think the basic question isn't "Why won't these owners pay the tax?" it is, "Why should they pay the tax?" My bet is that the knee jerk answer is, "To win a title," or "To keep a good team together," but what's the return on that? Check out this post's sub-section "Win a Championship, Lose More Money?" for further explanation.

The investment generates Goodwill, sorta. If you win a lot and create a solid following, then you will theoretically lose fewer fans in the lean times, but that's so speculative. I'm not inside one of these teams, but I find it virtually impossible to believe that any sensible financial justification could be made for the Pacers or OKC or Milwaukee or Memphis to go into the tax. You may dip into it, but with three max guys & Ibaka, OKC was going to be setting up camp in the tax (or playing with those 4, and 10 rookie second rounders).

If I'm talking to a Pacer fan who believes that Simon should pay the tax to chase a title, I'm looking at two people (Simon & the fan) who want the same thing (a title/lots of good Pacer basketball), but only one of them who has to cough up the big bucks to get it. The hard, financial answer in markets like Indy, OKC, Milwaukee, Memphis, and most others is, "The market is not worth the additional investment," so they have to try to figure out how to achieve those goals within a spending constraint.

Of course, this is why most of these owners wanted a hard cap during the last lockout, and part of the problem created by luxury taxes that I discussed in this piece from 2011. People often point to the Thunder (and perhaps soon, the Pacers) being unable to keep their players together as an indictment of the new "Owners' system" from the 2011 CBA. It was, after all, supposed to help small markets, not hurt them.

But that's always been specious reasoning. Proponents of a hard cap don't want to create a system where small markets can keep their teams together. They (we) want a system where no one - including the New Yorks and LA's - can. From that point of view, Oklahoma City having to trade Harden is just the system working the way it's supposed to work. And Brooklyn being able to go $30 million into the tax - regardless of the success or failure of the moves - is just a reminder that this isn't the "Owners' system," but one of compromises and settling with another, not quite as powerful group (the NBPA) that is diametrically opposed to their goals.

And in that context, some owners have to make hard choices that others don't. These are done in view of a public that has one of the easiest choices imaginable - how to spend someone else's money.

***