The Current State of Baseball Economics

Palm Gift Lounge at the Ryan Howard All Star Bash

Yesterday, ESPN’s Rob Neyer published an article quoting Commisioner Bud Selig’s thoughts concerning the current state of baseball economics. Says Selig,

    Some teams lost money in 2009, baseball commissioner Bud Selig said Thursday after the final owners meeting of the year.

    “There was no question about that,” Selig said. “I don’t think the concerns have been ameliorated at all. I think the concerns are still there because all these people have their own economists.”

    Selig said final figures for this year are still being calculated and everyone is living in the most difficult economic times since the Great Depression. He declined to identify the teams.

    “I think of all the heartache that’s in the world,” Selig said. “We live in this environment. We don’t live in a bubble. And so, I think the clubs in some areas have been hit a lot harder than others.”

This seems to happen every year, where multiple MLB owners allege that their team has “lost money” and therefore needs any number of amenities, including, but not limited to: extra money towards the building of a new stadium, special tax relief, more money from the state, etc, etc, etc.

In almost all cases, these claims are unfounded. Owners are still getting fat off of their dealings with TV and radio contracts, gate receipts, apparel, and any of the other giant revenue streams brought in by the MLB.

And, while this year isn’t different at all in the grand scheme of things — considering that MLB is just as healthy as ever — a few things have changed. Most prevalent among these factors is that the ailing economy has limited the amount of disposable income Americans have – meaning they can’t spend as much money consuming Major League Baseball, driving down the income of MLB teams.

While it’s certainly logical to assume that some teams haven’t done as well as they usually do, its still unlikely that anyone has “lost” money. Don’t believe the headlines.  Whenever anyone says they have “lost money” on a major league franchise, it is the product of tax loopholes and accounting practices that allow them to state a loss, when they have in fact made money – and it’s not a new phenomenon.

The practice of depreciating team value was first put into practice by Bill Veeck in 1959. Veeck saw the opportunity to classify his players as assets, which, by GAAP (Generally Accepted Accounting Principles), would allow him to use all the money from depreciation to reduce the amount of taxes paid by the team.

When Veeck purchased his team, he determined the value of the players against the value of the team. At the time, he considered them to be 90% of the value of the team. He then depreciated the player expenses over 5 years. This sum was subtracted each year from the total amount of taxes paid by the team.

Take into consideration the following example. Mike Silver purchases the Brooklyn Dodgers for $100 million. He argues that the value of the players is 90% of the team’s value, which is $90 million. He is allowed to depreciate the value of the players equally over 5 years, which totals $18 million per year (which is $90 million / 5 years = $18 million per year) and subtract these losses from his taxes.

The team sees revenues of $50 million per year. Since they are in the 50% tax bracket, the team has to pay $25 million per year in taxes. Since the team has depreciated its assets by $18 million, they can subtract that value from the amount of taxes they have to pay. Therefore, they only pay $7 million in taxes ($25 million – $18 million = $7 million).

Other rules, such as the ownership of an S-Corporation, mean that baseball team owners can depreciate taxes of their other businesses by posting a loss in their baseball team. If, in the above example, they are able to depreciate the players by $30 million per year instead of $18 million, they will have $5 million in losses, after subtracting out the $25 million in revenues. Therefore, the owner can transfer this savings into one of its other businesses, and save this money as well.

Teams do this for a number of reasons. The first is for the reasons stated above, which is to pay less money in taxes. A second reason is to get more money from their home city when they build new stadiums. This strategy has been employed by almost every team in their pursuit for a new stadium.

Because stadiums are so expensive, teams pursue additional spending from their home city. If they can show that their team is less profitable than it actually is, it will appear to the city’s politicians that they need assistance to build their stadium, and therefore, the city will be more likely to give them tax money when buying their new stadium.

A third reason that teams will do this is to pay less money on loans that are based on profits. This has been used by many teams, including the Pittsburgh Pirates when repaying the loans on Three Rivers Stadium in the 1980s. The team had signed a contract with the city to pay loans on its new stadium through revenues gained through stadium operations.

Therefore, they had to account for depreciating expense before arriving at their operating income. Any time the team made a profit, they had to pay back the loan. The team used the GAAP rules to depreciate their player expenses and declare an operating loss. Because of this, they never paid back a penny on their loan through 1993, when they began asking for financing for a new stadium.

These principles, combined with the current state of baseball economics have some very important implications when dealing with the value of long term contracts. If baseball is in a recession, as Selig asserts, then the spending on free agent contracts will decline – potentially devaluing the worth of current contracts, especially those signed for multiple years.

Of particular importance are the changes in inflation rates of each baseball-dollar and the value of a win on free agency.

According to data at Fangraphs.com, the annual value of one win on the free agent market has been increasing at about 9.57% since 2002. (Dollars per win in millions: 2002 – $2.5; 2003- $2.8; 2004 – $3.1; 2005 – $3.4; 2006 – $3.7; 2007 – $4.1; 2008 – $4.5). According to Fangraphs’ model, any team wanting to purchase a win on the free agent market in 2008 would have to spend $4.5 million.

This inflation rate is very important to analyzing the current value of contracts and where free agency salaries are expected to go.

At this juncture, it is extremely difficult to make any sound predictions, unless you’re a world renowned baseball economist like Andrew Zimbalist. However, we can make a few interesting conclusions with the data at hand.

Going along with the current level of inflation, we can make a projections on the value of current free agent contracts. An excellent example is that of Mark Teixeira, lamented by all of Red Sox Nation when he signed with the Yankees for 8 years, $180 million through 2016, where he will be paid $22.5 million between 2011-2016. $22.5 million is quite a bit of money.

However, given an inflation rate of 9.57 percent per win, it becomes much easier for Teixeira to be worth his contract, even in the latter years of the deal.

Given a 9.57 percent inflation rate, here are the dollars per win through 2016, followed by Teixeira’s required “break even” point for dollars per win, or, stated another way, the number of wins he would need to be worth each year to break even:

2009: $4.93          4.056 WAR

2010: $5.40          3.703 WAR

2011: $5.919       3.803 WAR

2012: $6.486       3.469 WAR

2013: $7.106       3.166 WAR

2014: $7.786       2.889 WAR

2015: $8.532       2.637 WAR

2016: $9.348       2.407 WAR

Well, isn’t that interesting. Currently a 5.1 WAR player, Teixeira can drop off in production to roughly 2.5 wins by the end of his deal… under the old rules.

Now, in a new economic environment, it becomes much more difficult to tell what the break-even point is. If the value of free agent contracts were to not increase through 2016 (which is highly unlikely), then Teixeira would have to be a 4 win player by the end of the deal.

What if the price of a free agent win, instead, increased at 5% per year, at couple points above the rate of inflation? Then, Teixeira would have to be worth 3.4 WAR at the end of the deal.

What if the economy affects MLB free agents to drop the inflation level to 7 percent – a large decline, but not quite as shocking as a decrease to 5 percent. In this scenario, Teixeira’s would have to be worth 2.91 WAR.

With the current state of baseball economics in flux, this offseason becomes a very important in setting the tone for the value of free agents in this economy.

Jason Bay will be an interesting case to watch. Under the old rules, if Bay had signed for 4 years, $60 million, he would have to be worth at least 2.11 WAR. That’s a pretty favorable rate for the Sox – and is probably the reason why Bay’s agent passed up the deal. Even though all parties are aware that the cost of free agents will likely not increase at 9.57 percent in this economy, there’s no reason for him not to demand a deal in that range – or at least close to it. Still, Bay was worth just 3.5 WAR this season according to Fangraphs.com. So, maybe it isn’t the best deal for Boston after all.

Whatever happens with Jason Bay this offseason, the value of long-term contracts in this market are up in the air – and we may not have a true read on the projection of free agent deals for at least a few years. Not the best environment to be doling millions out to prospective free agents.

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