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The effective tax rate is a useful percentage when comparing taxes paid by two different companies.Â  It simplifies a comparison that is often misleading when using the marginal tax rate under a graduated, progressive tax system.

For an individual, the effective tax rate is equal to the total income taxes paid divided by the taxable income for the year.

For a company, the effective tax rate is equal to the tax expense for the year divided by the taxable revenue for that year.

Letâ€™s compare the tax situations of two companies:Â  ABC and XYZ.

Here are the graduated, tiered tax rates:

 Taxable Income Tax Rate \$0 to \$50,000 15% \$50,001 to \$75,000 25% \$75,001 to \$100,000 30% \$100,001 and above 35%

For the year ABC has taxable income of \$110,000, XYZ has taxable income of \$200,000.Â  Based on the tax table, each company has a marginal tax rate of 35%.Â

The total tax paid by ABC is \$24,750 (\$50,000*15% + \$25,000*25% + \$25,000*30% +\$10,000*35%).Â  ABCâ€™s effective tax rate is 22.5% (\$24,750/\$110,000).

The total tax paid by XYZ is \$56,250 (\$50,000*15% + \$25,000*25% + \$25,000*30% +\$100,000*35%).Â  XYZâ€™s effective tax rate is 28.125% (\$56,250/\$200,000).

XYZ has a higher effective tax rate than ABC even though both have the same 35% marginal tax rate.Â  This is because \$100,000 of XYZâ€™s taxable income taxed at the highest rate of 35%.Â  ABC only had \$10,000 taxed at this rate.

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