The Qualifying Offer Is a Poorly Designed Tax

The qualifying offer is a tax that is designed to depress the salaries of free agents. I’m not sure it actually does a great job of that, but what is clear is that it has a number of other effects on free-agent salaries and destinations.

As a starting point, economists distinguish between good taxes and bad taxes. Good taxes have a few key features.

  • They are efficient – the simplest way to think about efficiency is that a tax doesn’t change your preferences that much. Once a tax is imposed you can buy less stuff overall, but in similar proportions.
  • They are fair, and in this context we mean that entities in the same position get treated equally.
  • They should be relatively easy to predict and understand.

The QO is not a good tax. A few of the worst features follow.

The rate of tax decreases for better free agents

Good taxes don’t distort preferences — at least not very much. Most consumption taxes (certainly in Australia) are charged as a percentage of the value of an item. Say a high-quality beer costs $10, and a low-quality beer costs $5. You can either have one good beer or two bad beers. Add a 100% tax (ouch). A bad beer costs $10, and a good beer costs $20. You are trading off a good beer for two bad beers and your preferences likely don’t change a lot, although you can probably buy fewer beers overall. Instead of a percentage tax, change it to a $5 flat tax per beer. I am now trading off 1.5 bad beers for every good beer – the tax has biased me towards high-quality beer (even more!).

The qualifying offer works as the latter kind of tax.

Take Cespedes and Trumbo. I will use Dave’s valuations (adjusted to make the math easier). Before the QO, say I value Cespedes at $120 million and Trumbo at $60 million. I trade off one Cespedes for two Trumbos (that’s a lot of Trumbo!). Now, say I am picking 16th in the draft with a pick valued at $20 million. The costs bump up to $140 million for Cespedes and $80 million for Trumbo. The ratio drops to 1.75:1. If I am a rational GM, the qualifying offer has significantly increased my valuation of Cespedes, relative to what I would pay Trumbo.

What this means in a general sense is that the qualifying offer makes the top-end guys more appealing (along with the players that don’t have taxes imposed on them), and erodes the market for the mid-market free agents.

The chart below plots the tax rate for a team with a draft pick valued at $20 million, assuming the cut-off for a team to offer a QO is a valuation of $20 million. What it shows is you have three zones: your cheap, tax-free free agents, your high-end, relatively low-tax guys and your middle-of-the-market danger zone. That Ubaldo signing last year, sheesh.

QO Tax by valuation

It applies at different rates to different teams.

Good taxes are meant to be equitable. That can mean it treats everyone the same, but sometimes it means that they tax better-off individuals at a higher rate. The QO attempts to do the latter. Unfortunately it introduces a new distortion in to the market. Every team faces a different rate of tax (a different draft pick), and a different set of relative prices between players.

Partially, this makes sense. MLB values competitive balance, and this is another approach to achieving that. However, this introduces an interesting wrinkle. The teams with the best draft picks at stake (the best teams) are biased towards the top of the free-agent class (and free agents that don’t have picks attached). Unfortunately this means that the worst teams are driven to the middle of the free-agent class, which history suggests is exactly where you don’t want to be shopping (Happy competitive balance day, here’s your tax-free Jeff Suppan!). This would be like exempting the poorest families from paying tax on tobacco.

Competitive balance matters, but worrying about achieving it with every tax is probably not the best approach. If you use modern tax theory as your guide, all that matters is that the system as a whole achieves your competitive balance objectives. Deal with competitive balance through mechanisms where it makes sense to (like revenue sharing and the draft) and then charge all teams the same free-agent tax.

The marginal rate declines when you buy more.

This one is odd. As I mentioned above, this tax bears a lot of similarities to excise taxes on gambling, smoking or drinking. These are the taxes at the government imposes to save us from ourselves. Here, the odd wrinkle is that the rate of tax declines when you buy your second free agent. This would be like the government levying a high rate of tax on your first packet of cigarettes, but exempting you from paying tax on your second packet because we didn’t get through to you the first time. The qualifying offer incentivizes teams to binge on the free-agent market once they have broken the seal.

The qualifying offer might not even depress salaries.

This requires some further research, but if owners aren’t spending money on free agents, the best alternatives are the draft or international free agents (or, pocketing more money). But both of these areas are capped, and the QO tax itself is paid in draft dollars. So, it doesn’t necessarily follow that this tax will depress the amount paid to free agents. It certainly redistributes money away from mid-tier free agents to upper- and lower-tier free agents, but the impacts on total spending are ambiguous.

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This is good writing.