Loading the player...

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%.

RELATED TERMS
  1. Tax Bracket

    The rate at which an individual is taxed. Tax brackets are set ...
  2. Tax Rate

    The percentage at which an individual or corporation is taxed. ...
  3. Direct Tax

    A tax that is paid directly by an individual or organization ...
  4. Tax Base

    The assessed value of a set of assets, investments or income ...
  5. Tax Liability

    The total amount of tax that an entity is legally obligated to ...
  6. Flat Tax

    A system that applies the same tax rate to every taxpayer regardless ...
Related Articles
  1. Managing Wealth

    What is the Effective Tax Rate?

    The effective tax rate is the average rate at which an individual or corporation is taxed per year.
  2. Taxes

    Federal Tax Brackets

    Why do we have income tax brackets? What do they do for us? Read this to understand the basics and where to find your own bracket.
  3. Taxes

    What's a Marginal Tax Rate?

    The marginal tax rate is based on a progressive tax system, where tax rates for an individual will increase as income rises. This method of taxation aims to fairly tax individuals based upon ...
  4. Taxes

    Understanding Taxes

    Taxes are mandatory fees that individuals and corporations must pay to their governments.
  5. Taxes

    Do Tax Cuts Stimulate The Economy?

    Learn the logic behind the belief that reducing government income benefits everyone.
  6. Financial Advisor

    3 Federal Income Tax Facts You Didn't Know

    Learn about three federal income tax facts that most Americans may not know from one of the most trusted financial resources on the Web.
  7. Taxes

    Why Your Tax Bracket Is Not the Tax Rate You Pay

    Understanding how federal and state tax brackets work is important for tax planning – and for making sense of the political conversation around tax reform.
  8. Taxes

    The History Of Taxes In The U.S.

    The number of taxes that we now consider a given did not always exist. Find out how they arose.
  9. Taxes

    Calculating Net of Tax

    Net of tax is a figure that has been adjusted for taxes.
  10. Taxes

    A Concise History Of Changes In U.S. Tax Law

    We look at how U.S. taxes have changed since their inception.
RELATED FAQS
  1. How does the effective tax rate for an individual differ from that of a corporation?

    Read about the effective tax rate for individuals when compared with the effective tax rate for corporations, including how ... Read Answer >>
  2. How does the marginal tax rate system work?

    The marginal tax rate is the rate of tax that income earners incur on each additional dollar of income. As the marginal tax ... Read Answer >>
  3. How are effective tax rates calculated from income statements?

    Learn how to read an income statement and how to find the information necessary to calculate a company's effective income ... Read Answer >>
  4. What is the income breakdown for the effective tax rate?

    Read about the effective tax rate, how the marginal income tax brackets affect it and how the denominator in its formula ... Read Answer >>
  5. What's the difference between the marginal tax rate system and a flat tax?

    Find out about the difference between marginal tax rates and flat taxes. Gain insights on both systems and the arguments ... Read Answer >>
Hot Definitions
  1. Cover Letter

    A written document submitted with a job application explaining the applicant's credentials and interest in the open position. ...
  2. 403(b) Plan

    A retirement plan for certain employees of public schools, tax-exempt organizations and certain ministers. Generally, retirement ...
  3. Master Of Business Administration - MBA

    A graduate degree achieved at a university or college that provides theoretical and practical training to help graduates ...
  4. Liquidity Event

    An event that allows initial investors in a company to cash out some or all of their ownership shares and is considered an ...
  5. Job Market

    A market in which employers search for employees and employees search for jobs. The job market is not a physical place as ...
  6. Yuppie

    Yuppie is a slang term denoting the market segment of young urban professionals. A yuppie is often characterized by youth, ...
Trading Center