Thursday, February 19, 2009

One For You, Nineteen For Me

Well, the trade deadline is gone, and there’s a lot of odd analysis going down in hoopsland these days. This Rocky Mountain News article frets that “The Nuggets already have eight players next season committed to make about $66 million. That gives them $4 million for five additional roster spots if they want to stay under the tax line.” Well, our journalist friend sure is begging the question there. Is it reasonable to say that an NBA team sees the aggregate salary threshold triggering luxury tax as a bad thing in itself, rather than simply a wrinkle that must be considered in the marginal cost of players? The typical analysis fails to consider how profit-maximizers (whether idealized or rough-and-ready) make decisions. Similarly, this article from February 16th suggests that the likeliest reason why the Detroit Pistons traded away backup PG Alex Acker, he of the $711,517 salary, was so they could get under the luxury tax line, rather than as a business decision like any other: is the cost of the investment justified?

It makes little sense to say that the Pistons dumped Alex Acker so they could get under (or close to) the luxury-tax line per se. Rather, one could say that given the Pistons’ aggregate salary position above the tax line, Joe Dumars noticed that, among other available roster shuffling options, by cashiering Acker they could save twice his annual salary of $711,517, or $1,423,034. Presumably if the Pistons were only $1 above the luxury tax line, they would have been less keen to jettison Acker to save $711,517 (his total salary, plus $1 in tax). And if, say, Acker’s annual salary were $20 and the Pistons were $5 above the luxury tax line, it is hard to imagine their dumping Acker just to save $25. There is some value to carrying a third point guard. And there is a nonzero probability that basketball value translates into economic value: if Acker is able to fill in during a couple games when Rodney Stuckey is injured, say, and he helps the team win a couple games and improve playoff position, his presence could be responsible for millions of dollars of extra revenue from playoff home games.

Perhaps we could say that owners are chary of paying luxury tax because they do not want to help competitor teams. But the orders of magnitude here are tiny: by dumping Acker, the Pistons avoided paying out $711,517 / 23 , or about $30,936, of luxury tax to each team (the dollar-for-dollar tax penalty is divided equally among all non-tax-paying teams). It is hard to imagine this making much of a difference to any individual owner’s P&L statement. Besides, a lump-sum cash transfer should not affect the recipient teams’ marginal decision-making regarding rosters: presumably, the acquisition or dumping of players should hinge on whether their contract value is justified by the attendant extra revenues, regardless of the team’s existing profit-or-loss level. Perhaps tax considerations (and here we mean real government tax, not NBA ‘tax’) might influence an owner’s decision-making if his distributions from the team corporate entity suddenly increase. Additionally, risk-averse owners might be slightly more willing to take on the gamble of a new player contract when they perceive they are pulling in more cash flow from the team. But again, thirty thousand dollars should hardly make much difference, so it is hard to see why Joe Dumars would think in such a way.

I have been assuming here that general managers act as pure profit-maximizers on behalf of their owners. But in some cases, owners place (the perceived chance of) winning above profits, such as when Knicks owner James Dolan signed off on Isiah Thomas’s rash acquisitions of Steve Francis, Jalen Rose, Jamal Crawford, and the like. Other rich or overzealous owners like Mark Cuban or Paul Allen may act similarly. If this is the case, then all bets are off: tax-paying teams would be less likely to worry about the tax, and also less likely to worry about transferring cash to other teams.

To be sure, irrational economic behavior is not rare: both corporate and individual decision-makers often fixate on avoiding thresholds that are better seen as arbitrary points on a continuum of financial positioning. For example, grandmothers from the Great Depression are likely to caution, “Don’t take on debt. Pay off your loans.” Well, if you can borrow at interest rates lower than the rates of return you are likely to earn from investing that money, then you certainly should keep your loans, or borrow more. Heck, Merrill Lynch carried a leverage ratio of 28:1 at the end of 2007. A leverage ratio of 1:1, or less, is one (extreme) point along a continuum of possible outcomes, but hardly the only logical one. Similarly, there’s little use in fixating on one rule, “Don’t go above the luxury tax line”, if that constrains you from making prudent investments. Other economic actors use crude heuristics, rather than careful analysis, to make decisions. It may be that, given how the luxury tax line has been constructed under the Collective Bargaining Agreement [i.e. the tax line is set at (i) 61% of average team revenues, minus (ii) average team benefits for players, including pension, 401(k), medical, and life insurance], breaching that line is a useful signal that a team is probably paying too much, given the typical magnitude of other team costs such as leases, administration, marketing, and other overhead.

So okay, it’s possible that team owners and management, crippled by bounded rationality, are anchoring on the luxury tax line as a fulcrum of decision-making. But still, most team owners have acquired their wealth through outsized success in other businesses, so they know how to run a business; it is unlikely that they would be distracted so. There is little evidence that they are in fact making decisions as NBA reporters suppose they are. (Sadly, team revenues and profits are not publicly reported, and so we cannot correlate profitability against player salary outlays.)

What about the scribes who write about the NBA: why do they so blithely accept the salary tax number as some kind of Demilitarized Zone, not to be breached? One writer said that “owners treat the luxury tax threshold the way Dracula treats sunrise” . Well, to put it nicely, most NBA reporters probably got started as college sports reporters and worked their way up; though constant learning is ostensibly part of their job, they are not necessarily policy wonks. It is they who are more likely the boundedly rational ones, stuck in a conceptual scheme that makes no sense.

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