Will Athletes Fall Off the Fiscal Cliff?

            With the 2012 elections and General David Petraeus sex scandal having mostly faded from the public’s consciousness, the next big issue in politics appears to be the fiscal cliff. What is this cliff and how does it get fiscal? (Yes, making oblique allusions to 1980s pop songs is the best way to make a discussion on tax policy more interesting.)  President George W. Bush helped facilitate the passage of a series of mostly “temporary” tax cuts that were set to expire in 2010. While these cuts reduced marginal income tax rates for all income levels, the wealthiest Americans (individuals or married couples filing jointly that make $388,530 or more per year) were the greatest beneficiaries as their income tax rates reduced from 39.6% to 35%. With the country still feeling the impact of the 2008 recession and high unemployment rates, President Barack Obama and Congress decided to extend these tax cuts through 2012.

            As 2012 comes to an end, however, these tax cuts will automatically expire unless Congress and the President agree to another extension or a permanent solution that reduces marginal tax rates. While promising to fight for lower and middle class tax relief, a key plank of President Obama’s reelection campaign hinged on letting the tax rates return to the 39.6% rate.

            A recent Forbes SportsMoney article showcases how the expiration of the tax cuts (or looming tax increases) would impact athletes who use their physical skills to become wealthy Americans. In a blog post entitled “Could Tax Savings Expedite Free Agent Baseball Signings?”, Tony Nitti argues that baseball players have an economic incentive to ensure as much of their income as possible counts as being earned in 2012. Because the minimum annual salary for a major league baseball player is $480,000, every single major league baseball player falls in the highest income tax bracket. Their rates will increase by 4.6%, and that could mean paying thousands of dollars more a year in taxes. Therefore, players will look to sign contracts as quickly as possible to achieve major tax savings.  For example, suppose a team would “sign [Josh Hamilton] to a 7-year, $140 million deal. If Hamilton’s agent, Michael Moye, is successful in moving $15 million of the contract into a 2012 signing bonus, Hamilton stands to save $825,000 in federal income tax.” Hamilton would achieve these savings because as much income as possible would be taxed at 35% rate instead of the 39.6% rate.

            While Nitti is accurate that marginal tax rates will increase for baseball players, he omits the fact that most people in the highest income brackets do not pay the marginal rate. In fact, the effective tax rate (what people actually pay in taxes) for the highest income tax payers is often far lower than the marginal income tax rate. One of the key platforms of Governor Mitt Romney’s presidential campaign was to eliminate deductions for the wealthiest Americans in order to generate billions of dollars in government revenues that could be used to reduce the federal government’s budget deficits. By definition, that means that there are billions of dollars in deductions being taken by wealthy Americans, including athletes, for things like retirement accounts, healthcare insurance, mortgages, capital gains, charitable giving, and education. In addition, aggressive accounting measures such as creating trusts or deferring income into overseas accounts create alternative methods to reduce one’s tax burden. According to the Urban Institute and the Brookings Institution, these efforts have helped 80.3% of people making over $200,000 pay an effective annual income tax rate of 25% or under from 2000-2008. This also means that the tax savings players would achieve by signing in 2012 versus 2013 will be dramatically less since their effective tax burden would be so much lower than the marginal rate.    

            Another major problem with Nitti’s analysis is that he fails to account for state income tax rates. In particular, Florida, Texas, and Washington all have baseball teams where players (or any individual) pay no state income tax. This is not the first time that someone has failed to account for state income tax rates when evaluating athlete compensation. The most famous example of when many people “forgot” to factor in state income tax rates occurred with Lebron James. While many people criticize James decision to leave Cleveland Cavaliers, most at least found it admirable that he took less money to join the Miami Heat. In reality, James is actually making more money by going to Miami than by staying in Cleveland because he pays no state income tax in Florida. Baseball players’ agents can and will factor in state income tax rates before making any decisions about where their clients will play for the 2013 season. Rushing to make a deal without factoring in effective tax rates or state income taxes would be a penny wise but more than a pound foolish.