Effective tax rate typically applies to federal income taxes and doesn’t take into account state and local income taxes, sales taxes, property taxes, or other types of taxes that an individual might pay. The effective tax rate calculation is a useful metric for benchmarking the effective tax rates of two or more entities.
- The effective tax rate relates to an individual’s or company’s overall tax rate, rather than its marginal tax rate.
- A marginal tax rate is the highest tax bracket an individual or corporate is taxed at based on the highest tier of income its earnings fall into.
- An effective tax rate is calculated by taking the actual income tax expense and dividing it by the company's actual net income.
- Effective tax rate is often used by investors as a profitability metric for a company as it measures how well a company utilizes tax-advantaged strategies.
- The reason for fluctuations in a company’s effective tax rate are even more important than the fluctuation itself, and a company's effective tax rate may be substantially less than its marginal tax rate.
Effective Tax Rate
A taxpayer's effective tax rate is the average rate at which their income is taxed. Although taxpayers use tax tables to determine their tax liability, these tax tables lack several important pieces of information.
First, effective tax rates are a blend of all the rates across a tax table. An individual's Federal income tax liability may be assessed across the 10%, 15%, and 18% tax brackets based on their income level. The taxpayer's effective tax rate will calculate the blended average rate across these tiers.
Second, effective tax rates reflect tax legislation that incentivizes and potentially reduces income that is taxable. A company or individual may be interested in measuring the actual tax they paid against the actual taxable income they report. This information may be especially important when comparing the tax-efficiency of similar companies or assessing the implications of moving to state with less-favorable personal tax implications.
An effective rate is possible within the United States for individuals because of the current progressive Federal tax system. Individuals and corporations are assessed taxes at different rates based on different levels of taxable income. As taxable income increases, the marginal tax rate for that tier of income increases. It is because of these varying rates that a blended, effective average rate is different than the actual bracket rates.
Barring a prior-year assessment or catch-up liability, almost all taxpayers will have an effective tax rate lower than their marginal tax rate.
Income Statements and Rate of Taxation
Income statements offer a quick overview of the financial performance of a given company over a specified period of time, usually annually or quarterly. On an income statement, you can view revenues from sales, cost of goods sold (COGS), gross margin, operating expenses, operating income, interest and dividend expenses, tax expense, and net income. The income statement is the benchmark financial statement for determining the profitability of a company.
Along the calculations of determining net income, a company often publicly discloses net income prior to taxes. This calculation, often excluding debt service charges as well, is called Earnings Before Interest and Taxes (EBIT). After interest in considered, taxes are calculated on taxable income and deducted to arrive at net income.
A company does not provide its actual percentage rate of taxation on the income statement. Still, you can figure out the effective tax rate by using the rest of the information on the income statement.
Calculating Effective Tax Rate
The effective tax rate is the overall tax rate paid by the company on its earned income. The most straightforward way to calculate effective tax rate is to divide the income tax expense by the earnings (or income earned) before taxes. Tax expense is usually the last line item before the bottom line—net income—on an income statement.
Effective Tax Rate=Earnings Before TaxesTax Expense
For example, if a company earned $100,000 before taxes and paid $18,000 in taxes, then the effective tax rate is equal to 18,000 ÷ 100,000, or 0.18. In this case, you can clearly see that the company paid an overall rate of 18% in taxes on income.
You can easily calculate a company's effective tax rate based off their income statement, while you can easily calculate an individual's effective tax rate off their 1040.
Effective Tax Rate vs. Marginal Tax Rate
The effective tax rate varies from the marginal tax rate, which is the tax rate paid on an additional dollar of income. The effective tax rate is a more accurate representation of a person’s or company’s overall tax liability than their marginal tax rate, and it is typically lower.
When considering a marginal tax rate versus an effective tax rate, bear in mind that the marginal tax rate refers to the highest tax bracket into which a person’s or company’s income falls. In the United States, an individual’s income is taxed at rates that increase as income hits certain thresholds. Two individuals with income in the same top marginal tax bracket may end up with very different effective tax rates, depending on how much of their income was in the top bracket.
Consider the example above where a company pays an effective tax rate of 18%. In reality, the company is likely assessed the flat 21% flat corporate tax rate. Because of tax-advantaged shelters and tax benefits, a company's marginal tax rate (21% in this example) will likely vary from the actual rate of interest it pays.
Significance of Effective Tax Rate
Effective tax rate is one ratio that investors use as a profitability indicator for a company. This amount can fluctuate, sometimes dramatically, from year to year. However, it can be difficult to immediately identify why an effective tax rate jumps or drops. For instance, it could be that a company is engaging in asset accounting manipulation to reduce its tax burden, rather than a managerial or process change reflecting operational improvements.
Also, keep in mind that companies often prepare two different financial statements; one is used for reporting, such as the income statement. The other is used for tax purposes. Expenses that are allowed as deductions or credits for tax purposes may cause variances in these two documents. If a company is effectively utilizing tax deductions and credits, then its effective tax rate will be lower than a company that is not effectively using these strategies.
Example of Effective Tax Rate
Consider the consolidated income statement below for Apple, Inc. for the three-month period ending June 25, 2022. The comparative statement also shows the nine-month period ending June 25, 2022 as well as financial information covering the same period from the prior year.
Dissecting the information above, an investor can arrive at a few different effective tax rate calculations below. Be mindful that all dollar amounts below are in millions.
- Three-month period (2022): $3,624 / $23,066 = 15.7%
- Three-month period (2021): $2,625 / $24,369 = 10.8%
- Nine-month period (2022): $15,364 / $94,446 = 16.2%
- Nine-month period (2021): $11,830 / $74,129 = 15.9%
As a result, a few conclusions can be drawn regarding Apple's effective tax rate(s). In the short-term, the company received favorable tax treatment during the first part of last year as its effective tax rate was substantially lower than other periods. In addition, the effective tax rate Apple pays is substantially lower than a flat 21% corporate tax rate.
Who Pays the Highest Effective Tax Rate?
Individuals within the highest marginal tax bracket may have the highest effective tax rate as a portion of their income is being assessed taxes at the highest marginal rate. However, these taxpayers may also have the means and resources to implement tax-avoidance strategies, thereby reducing their taxable income and resulting effective tax rate.
What Is the Purpose of an Effective Tax Rate?
Calculating a company's tax rate benefits individuals inside and outside of a company. Investors outside of a company can take a company's effective tax rate and better understand their corporate structure and methodologies implemented to be most resourceful. Those within a company are interested in the effective tax rate as it is used when budgeting and planning.
How Can I Reduce My Effective Tax Rate?
Companies and individuals can reduce their effective tax rate by earning tax-free revenue. This may include receiving gifts or receiving tax-free income such as disability insurance or municipal bond interest income. There are also tax incentives for certain one-time actions such as making a qualified withdrawal from a Roth IRA or selling your home and meeting the requirement to exclude the gain from tax reporting.
Can An Effective Tax Rate Be Negative?
Yes. If a company or individual receives a tax refund, the taxpayer is considered to have a negative effective tax rate.
Do Billionaires Pay Lower Effective Tax Rates?
Every individual and company's effective tax rate will vary. However, many wealthy individuals earn income that is not taxed. Consider a wealthy individual that collateralizes their large investment portfolio to secure low-interest personal loans to live off of. Because the individual does not sell any personal securities, they technically have no taxable gain to recognize (and therefore incur a tax liability for). It is investment and financial planning strategies like these that allow some billionaires to pay very low effective tax rates.
The Bottom Line
While a marginal tax rate tells a taxpayer the highest tax bracket they are in, an effective tax rate tells a taxpayer what their average tax rate is. An effective tax rate is the quotient of a taxpayer's total tax expense divided by their taxable income. Investors use this effective tax rate to compare the resourcefulness of a company's tax-avoidance strategies, and companies use an effective tax rate for cashflow and budget planning.