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The effective tax rate is a useful percentage when comparing taxes paid by two different companies.  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.

Let’s compare the tax situations of two companies:  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.  Based on the tax table, each company has a marginal tax rate of 35%. 

The total tax paid by ABC is $24,750 ($50,000*15% + $25,000*25% + $25,000*30% +$10,000*35%).  ABC’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%).  XYZ’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.  This is because $100,000 of XYZ’s taxable income taxed at the highest rate of 35%.  ABC only had $10,000 taxed at this rate.

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