Each year, clubs that exceed a predetermined payroll threshold are subject to a Competitive Balance Tax -- which is commonly referred to as a "luxury tax." Those who carry payrolls above that threshold are taxed on each dollar above the threshold, with the tax rate increasing based on the number of consecutive years a club has exceeded the threshold.
The threshold was $189 million from 2014-16, but the following increases were put in place per the 2017-21 Collective Bargaining Agreement:
2017: $195 million*
2018: $197 million
2019: $206 million
2020: $208 million
2021: $210 million
*For 2017 only, clubs that exceed the threshold shall pay the average between what their luxury tax would be under the 2017-21 Collective Bargaining Agreement rules and what it would have been per the previous CBA.
A club exceeding the Competitive Balance Tax threshold for the first time must pay a 20 percent tax on all overages. A club exceeding the threshold for a second consecutive season will see that figure rise to 30 percent, and three or more straight seasons of exceeding the threshold comes with a 50 percent luxury tax. If a club dips below the luxury tax threshold for a season, the penalty level is reset. So, a club that exceeds the threshold for two straight seasons but then drops below that level would be back at 20 percent the next time it exceeds the threshold.
Clubs that exceed the threshold by $20 million to $40 million are also subject to a 12 percent surtax. Meanwhile, those who exceed it by more than $40 million are taxed at a 42.5 percent rate the first time and a 45 percent rate if they exceed it by more than $40 million again the following year(s).
Beginning in 2018, clubs that are $40 million or more above the threshold shall have their highest selection in the next Rule 4 Draft moved back 10 places unless the pick falls in the top six. In that case, the team will have its second-highest selection moved back 10 places instead.
History of the rule
The 2012-16 Collective Bargaining Agreement required clubs to pay a 17.5 percent luxury tax for first-time overages. Clubs that exceeded the threshold for two, three and four consecutive years were taxed at 30, 40 and 50 percent rates, respectively.
In 2013, the Los Angeles Dodgers exceeded the Competitive Balance Tax threshold with a payroll well over $200 million in total. The Dodgers also exceeded the luxury tax threshold in 2014, 2015 and 2016, incurring progressively steeper penalties each year as a result.