From a long time Royals fan perspective:
The Royals had high payrolls (top 5 or 10) for many years in the 1980's and 90's and they did well financially under Ewing Kauffman. I have often mocked the market size debate for a long time but we will leave that for another day. They were winning a lot of games back in those years.
It wasn't until Kauffman's death and later the strike in 1994 where their payroll rank plummeted. The Royals payroll situation was never based on their "small market", but instead it was based on how deep the owners pockets were, and how willing to spend the owner was.
The board that ran the team for a time after Kauffman's death felt it was necessary to keep the payroll low in order to keep the team in Kansas City, prove profitability and allow numerous people to get a piece of the pie. In the years after that the Royals were year in and year out one of the most profitable teams. In the mid 2000's the Royals were receiving $15-30 million in tax money from the other teams, and all of that was going in to Glass's pocket. It was their choice to hold a low payroll and not be competitive, it wasn't some outside force holding them down.
Magically, now that franchise values have exploded along with the wealth of David Glass, the Royals are able to compete with a lot of teams for middle tier free agents and run middle of the pack in overall spending. It is not the size of your market that matters, its the willingness and capability to spend of the owner.
Another factor that plays in to the Royals current situation. People often don't realize this but the Royals are one of, if not the, oldest teams in baseball based on average age (depends on which source you look at/current roster vs opening day). Their payroll now is higher in an attempt to extend their window of winning. They have numerous players who have gone to arbitration multiple years, no rookies, and only a few guys who are pre-arb eligible.
For years and years people in this city screamed that it was unfair what the Yankees were doing. It was unfair that the Royals couldn't pay an outfield of Damon, Dye and Beltran to stay together. But it was all bullshit. It was all based on the willingness and capability of the owner to spend. Especially their essentially totally absent spending in latin america.
No one should be punishing the perceived larger markets strictly because they are willing to spend more money. And at the same time no one should punish a team for rebuilding. I believe their are plenty of rules in place to help smaller market teams out such as the luxury tax and competitive balance picks.
Putting a cap on spending will do nothing to improve the game. It will do nothing to improve "parity". It will only punish the players and put more money back in to the franchises instead of being spent where it should be on the field.