What is the Effective Tax Rate?

The effective tax rate is the average tax rate paid by a corporation or an individual. The effective tax rate for individuals is the average rate at which their earned income, such as wages, and unearned income, such as stock dividends, are taxed. The effective tax rate for a corporation is the average rate at which its pre-tax profits are taxed, while the statutory tax rate is the legal percentage established by law.

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Effective Tax Rate

How the Effective Tax Rate Works

An individual's effective tax rate is calculated by dividing the number on line 16 of their 1040 Form, "Total Tax," by the number on line 11(b) of that form, "Taxable Income." For corporations, the effective tax rate is computed by dividing total tax expenses by the company's earnings before taxes.

An individual or a corporation's effective tax rate is typically lower than their marginal tax rate.

So, expressed as formulas, the effective tax rates (ETR) for individuals and corporations look like this:

            For an individual: ETR = Total Tax ÷ Taxable Income

            For a corporation: ETR = Total Tax ÷ Earnings Before Taxes 

The effective tax rate typically refers only 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. To determine their overall effective tax rate, individuals can add up their total tax burden and divide that by their taxable income. This calculation can be useful when trying to compare the effective tax rates of two or more individuals, or what a particular individual might pay in taxes if they lived in a high-tax vs. a low-tax state—a consideration for many people thinking about relocating in retirement.

Key Takeaways

  • Effective tax rate represents the percentage of their taxable income that individuals have to pay in taxes.
  • For corporations, the effective corprate tax rate is the rate they pay on their pre-tax profits.
  • Effective tax rate typically refers only to federal income tax, but it can be computed to reflect an individual's or a company's total tax burden.

Marginal vs. Effective Tax Rate

The effective tax rate is a more accurate representation of a person's or corporation's overall tax liability than their marginal tax rate and is typically lower. When considering the marginal versus an effective tax rate, bear in mind that the marginal tax rate refers to the highest tax bracket into which their income falls.

In a graduated or progressive income-tax system, like the one in the United States, income is taxed at differing rates that rise as income hits certain thresholds. Two individuals or companies with income in the same upper marginal tax bracket may end up with very different effective tax rates, depending on how much of their income was in the top bracket.

An Example of an Effective Tax Rate

For example, imagine a graduated tax system where income under $100,000 is taxed at 10%, income between $100,000 and $300,000 is taxed at 15% and income over $300,000 is taxed at 25%. Now consider two individuals who both hit the upper tax bracket of 25%, although one had taxable income of $500,000, while the other had taxable income of $360,000.

Both individuals would pay 10% on their first $100,000 of income, or $10,000. Both would then pay 15% percent on their income between $100,000 and $300,000, or $30,000 (15% of $200,000).

Finally, both would also pay 25% on their earnings over the $300,000 threshold. For the individual with $360,000 in taxable income, that would come to $15,000 (25% of $60,000). But for the individual with $500,000 in taxable income, the tax would be $50,000 (25% of $200,000). Their total tax obligations would be $55,000 and $90,000, respectively.

While both individuals might say they're in the 25% bracket, the one with the higher income has an effective tax rate of 18% ($90,000 in tax divided by $500,000 in income), while the other's effective tax rate is 15.3% ($55,000 divided by $360,000).