The average tax rate paid by a corporation or individual is the effective 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 an individual might pay. The effective tax rate calculation is a useful metric for benchmarking the effective tax rates of two or more entities or trying to understand the financial advantage or disadvantage of living in a high-tax vs. a low-tax state.

Key Takeaways

  • The average tax rate paid by a corporation or individual is the effective tax rate.
  • The effective tax rate is the average tax rate paid by the company on its earned income.
  • Effective tax rate is often used by investors as a profitability metric for a company.

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, gross margins, after-tax earnings and overhead costs, which is a litany of useful information.

A company does not provide its actual percentage rate of taxation on the income statement. Expense from taxes is usually the last line item before net income calculation, and you can figure out the effective tax rate using the rest of the information on the statement.

Calculating Effective Tax Rate

The effective tax rate is the average tax rate paid by the company on its earned income. Locate net income on the company's income statement (this line may sometimes read "earnings"). Net income shows how much revenue a company is able to keep after deducting taxes, and the two preceding line items should identify both revenue and taxes paid.

The most straightforward way to calculate effective tax rate is to divide the income tax expenses by the earnings (or income earned) before taxes. For example, if a company earned $100,000 and paid $25,000 in taxes, 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 average rate of 25% in taxes on income.

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 a tax burden, rather than a 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, and the other is used for tax purposes. Actual tax expenses may vary in these two documents.