Salary Caps 101 (Part II)  by: Matt Witting      10 February, 2003

"Football has it. Basketball just got it. Hockey and baseball need it. What is the "it" I'm referring to? No, not rickets. I am talking about salary caps. A salary cap is a limit on how much a team can spend on players. Depending on the loopholes, salary caps have a tremendous effect on how sports teams recruit and hire its players."
-Chris Lindsay, freelance columnist

To explain salary caps, start with the name. A "salary cap" is not actually a cap on individual salaries but a payroll or cost-of-labor cap. The managers of the various franchises meet and agree to inhibit the labor market by refusing to spend more than a certain, pre-determined amount on payrolls, often less than some franchises already dole out. Some sports do have some sort of cap on individual player salaries, but these are typically set up with a number of exemptions and exceptions to get around the rule. For example: the NHL limits the salary of rookies and players under a certain age but doesn't restrict performance bonuses to them. The NBA has individual salary limits in place but there are so many ways around them that they are rarely a factor (more on this later). The net effect of the types of caps currently in use is to put more money in the hands of owners and less in the hands of labor: the players.

There are two broad types of caps: the "soft" cap and the "hard" cap. The NBA features a soft cap (interestingly one of the primary architects of the NBA cap is current NHL commissioner Gary Betteman). The NFL has a hard cap. What's the difference? From the FAQ for the NBA salary cap: "The NBA has a soft cap. A hard cap doesn't allow the cap to be exceeded for any reason. A soft cap, which the NBA has, contains exceptions under which a team can be over. In fact, historically very few teams are ever under the cap during a season."

Soft Cap: The National Basketball Association

Basketball had a cap in 1946-47, gave it up, and then implemented the current version (more or less) in 1984-85. The current NBA cap limits payrolls of NBA teams to 55% of Basketball Related Income for the league. The figure will rise to 57% in 2004-05, the last season of the Collective Bargaining Agreement (CBA), and can be terminated if the average NBA player salary drops below the average NFL, NHL or MLB player salary (among other reasons). Basketball Related Income (BRI) requires some complicated math but it includes revenue from tickets, advertising, local concession and souvenir sales, local media and other league, team and arena income streams. In 2001-02 the cap was set at $42.5 million. Two teams, Detroit and the LA Clippers were under the cap; Detroit by $800,000 and the Clippers by $8.8 million. The 28 other teams were all over the cap, 16 teams by more than $10 million, and 2 teams by more than $40 million (Portland and the New York Knicks). The reason teams were able to exceed the cap by so much is because many of the exceptions (including the famed "Larry Bird Exemption") apply to players who do not exercise their free agent rights or who remain with the same team for more than a couple of years. The NBA claims that "The basic idea is to try to promote the ability for players to stay with their current team. Nobody likes it when a player plays with a team his entire career, the fans love him, he wants to stay and the team wants to keep him, but he has to leave because the team is unable to offer him a large enough contract."

The NBA also has a "luxury tax" in effect. If average salaries league-wide for a season go over the agreed upon limit (55% of BRI) then there is an escrow fund (composed of 10% of player salaries) held back from players' paychecks that is reimbursed equally to franchises (thereby reducing the amount teams spend on player salaries) until the 55% limit is restored. If the 10% escrow fund is not sufficient, then the highest spending teams (the ones assumed responsible for the salaries being so far over the limit) are taxed the remaining amount to reimburse the other owners. Player salaries are also capped depending on tenure in the league, but there are so many exceptions to this rule that it rarely has a major impact on the salaries of star players, the ones the true cap on salaries is supposed to affect. Obviously the NBA salary cap and luxury tax structure are not overly constraining and therefore qualify as a soft cap. As NHL commissioner Gary Betteman was the primary composer of the 1984 NBA deal, the expectation is that he will press for something similar in the NHL.

Hard Cap: The National Football League

The NFL cap is often called a hard cap. It was introduced in 1994 and operates on many of the same principles as the NBA cap. It limits franchises from spending more than 63% of the League-determined Defined Gross Revenues (DGR, similar to the BRI of the NBA). The cap was calculated at roughly $67.4 million for the2001-02 season. This seems to be much more than the NBA cap, but remember that NFL teams have an average of 57 players on the roster as compared to under 17 in the NBA. Despite the cap on payrolls, player salaries have continued to rise since 1994, and at a rate outpacing the growth rate of the DGR number. Because of this teams have scrambled to find ways to circumvent the cap (there are no obvious loopholes written in) so that they can keep/sign good players. The primary way that this is done is through guaranteed signing bonuses, sometimes as large as 2 or 3 times the average yearly salary on the contract, that are spread over the life of the contract when determining cap numbers. For example, a player signed for $1 million per year for five years ($5 mil total) is given a $10 million signing bonus (paid when the contract is signed). When calculating the impact on the salary cap, though, the player does not count $11 million the first year and $1 million per year thereafter (the way he is paid), he can count as $3 million each year of the contract (($10 mil +$5 mil) / 5 years). The upside for the player is that he is guaranteed $10 million (as NFL contracts can be terminated by the team at any time, unlike in other pro sports). The team gains because they get to spend to attract a star player but don't lose a huge chunk of cap space. The major downside happens if the player is injured, cut, traded or retires in which case the bonus still counts against the team even though the player isn't there, and is accelerated to be paid entirely in the current year. If the player in our example suffers a career-ending arthritic big toe after the first season, the team loses $8 million of cap room for year two of the contract. This so-called "dead money" has become the bane of many an NFL franchise.

During the 2001-02 NFL season 18 of the 31 teams spent more than the $64 million salary cap thanks to the signing bonus and deferred money. 7 teams were more than $10 million over the cap, 2 were $20 million over and 1 (Denver) was $48,000 shy of being $30 million over the cap. At the other end of the scale, 2 teams (Dallas and Washington) were more than $10 million under the cap because they were weighted down with "dead money". The NFL salary cap seems to make each team's spending from year to year look like a sine wave: it goes well over the cap for a couple of years, then drops well below it for a couple of years to compensate, then jumps back up as soon as cap space appears.

The National Hockey League does not have a salary cap of any sort, but the existing NHL CBA contains clauses that limit the minimum compensation for all players and the maximum entry-level compensation for players under the age of 25. Article 9 of the NHL CBA limits the maximum yearly compensation for rookies to just over $1 million in salary and 50% of that in signing, reporting and roster bonuses. Performance bonuses are not affected. After a length of time determined by the age of the player when the first contract was signed (not exceeding three years) the limits come off. This clause allows the NHL to avoid many of the problems that the other leagues experience with regards to getting rookies signed. Major League Baseball has had cases where lower-payroll teams draft inferior players in the early rounds because they know that they won't spend what the high rated prospects' agents demand. While there are rookie holdouts and unsigned draft picks in hockey, it's typically not due to affordability.

Revenue Sharing and Payroll Taxes

Revenue sharing is the current hot topic in MLB and is reportedly being considered for the NHL as well. The details of revenue sharing plans vary greatly but the basic principle remains the same: determine the most profitable franchises, take portions of their revenues, distribute these funds to less profitable franchises. Often the revenues to be shared are those from local TV/radio contracts. The value of those deals depends heavily on the demographics of the area surrounding each franchise and, as such, are "dumb luck" revenues not greatly affected by skillful or poor management. Wealthier owners have obvious reasons for opposing significant revenue sharing, not least because under existing plans small market owners have been known to simply pocket the shared money rather than use it to improve their team. The MLB agreement of last summer increased the amount that the richer teams will contribute to the poorer teams from $169 million to $258 million, and the rich ones will also have to contribute 34% of locally generated revenues, up from 20%. Players tend to shy away from revenue sharing as it can limit player salaries, although they regard it as a lesser evil than a salary cap.

A variation on revenue sharing is the so-called "luxury" or "payroll" tax. Under this scheme teams that spend more than a certain amount on payroll are assessed fines for every dollar they spend over the soft ceiling. Typically the rate is rather steep, even as much as a direct 1-1 ratio. The fines are distributed to poorer teams. These payroll taxes raise the same issues as standard revenue sharing, but also are seen to be semi-ineffective in limiting big money teams. If a team can afford to exceed a hypothetical $50 million ceiling by $3 million to sign a key player, they can typically afford the $1-$3 million fine that would accompany it. The New York Yankees originally stated that they would get under the luxury tax threshold that was instituted during the MLB crisis last summer (approximately $117 million). An off-season of chasing Japanese free agents later they are pushing the $160 million dollar line and have not yet signed all of their players. They will pay at least 20% of the overage as a penalty, but don't seem to mind. Luxury taxes are seen as more palatable than revenue sharing by most observers because they are seen as only punishing the very rich and even then only if the rich deliberately spend more than agreed upon limit.

One method to assuage fears that the beneficiaries of revenue sharing/luxury taxes simply pocket the majority of the proceeds is the minimum payroll, something generally not found in pro sports. If a maximum allowable payroll is established through a cap (hard or soft), a tax cut-off line or any other method, some owners fight to include a minimum payroll level. This is to ensure that smaller market teams don't simply adjust their payrolls downward in response to the lowering of the maximum. The players unions support this balancing mechanism as it ensures that a minimum wage for a team is established as well as a maximum thereby guaranteeing that the players will continue to receive a reasonable piece of the pie.

All these methods of reigning in team payrolls have different effects, positive and negative, on the leagues where they have been implemented. Theorizing about what they will do is all fine and dandy, but the real life reaction may not be what was planned.

Part I: Overview
Part II : Salary Caps 101
Part III: The Real World
Part IV: Conclusions

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