What is the 'Effective Tax Rate'
The effective tax rate is the average rate at which an individual or corporation is taxed. The effective tax rate for individuals is the average rate at which their earned income is taxed, and the effective tax rate for a corporation is the average rate at which its pre-tax profits are taxed.
BREAKING DOWN 'Effective Tax Rate'
An individual's effective tax rate is calculated by dividing total tax expense from line 63 of his 1040 Form by his taxable income from line 43 of that form. For corporations, the effective tax rate is computed by dividing total tax expenses by the firm's earnings before taxes.
Which Taxes Are Included in Effective Tax Rates?
In many cases, effective tax rate only refers to income taxes incurred by taxpayers and does not include sales tax or other types of taxes. However, in other cases, analysts include excise taxes as well payroll taxes. This can be especially useful when trying to compare the effective tax rate of two or more individuals, as income tax is only a portion of the total tax paid by most taxpayers. To calculate effective tax with these inclusions, add together all of the tax under consideration and divide it by the individual's income.
Effective Tax Rate Versus Marginal Tax Rate
The marginal tax rate refers to the tax bracket into which a business's or individual's income falls. The effective tax rate is typically a more accurate representation of tax liability than an individual or business's marginal tax rate. For example, two companies with income in the same upper marginal tax bracket may end up with difference effective tax rates depending on the amount of their earnings that fall into each tax bracket.
For example, imagine a tax system where earnings under $100,000 are taxed at 10%, earnings between $100,000 and $300,000 are taxed at 15%, and earnings over $300,000 are taxed at 25%. Two businesses both fall into the upper tax bracket. However, one earned $500,000, while the other only earned $360,000. Both businesses pay 10% or $10,000 on their first $100,000 of earnings, and they both pay 15% or $30,000 on their earnings between $100,000 and $300,000. Both companies also pay 25% on their earnings over the $300,000 threshold, but that equates to $50,000 for one company and only $15,000 for the second company. With a total tax liability of $90,000, the company with $500,000 in revenue pays an 18% effective tax rate, while the company with $360,000 in income pays a total income tax bill of $55,000, making its effective tax rate only 15.2%.