The effective tax rate is the percentage of income paid in taxes by a corporation or individual. It relates to the company’s overall tax rate rather than its marginal tax rate.

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.

Key Takeaways

  • The effective tax rate relates to an individual’s or company’s overall tax rate, rather than its marginal tax rate.
  • Effective tax rate is often used by investors as a profitability metric for a company.
  • The reason for fluctuations in a company’s effective tax rate are even more important than the fluctuation itself.

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.

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.

For example, if a company earned $100,000 before taxes and paid $25,000 in taxes, then the effective tax rate is equal to 25,000 ÷ 100,000, or 0.25. In this case, you can clearly see that the company paid an overall rate of 25% in taxes on income.

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. This is referred to as a progressive income tax system. 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.

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.