Effective Tax Rate Definition

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Effective Tax Rate Definition

What Is the Effective Tax Rate?

The effective tax rate is the percentage of an individual’s or corporation’s income that is paid in taxes. Individuals’ effective tax rate is the average rate at which their earned and unearned income, such as stock dividends, are taxed. A corporation’s effective tax rate is the average rate at which its pre-tax earnings are taxed, while the statutory tax rate is the legal percentage set by law.

Key Takeaways

  • Individuals’ effective tax rate is the proportion of their taxable income that they pay in taxes.
  • The effective corporate tax rate is the rate that firms pay on their pre-tax earnings.
  • Although the term “effective tax rate” usually refers primarily to federal income tax, it may be calculated to represent an individual’s or a company’s entire tax burden.

Understanding the Effective Tax Rate

An individual’s effective tax rate may be calculated by glancing at their 1040 form and dividing the figure on line 16, “Total Tax,” by the number on line 11(b), “Taxable Income.” The effective tax rate for companies is calculated by dividing total tax costs by profits before taxes.

The effective tax rates (ETR) for individuals and companies are expressed as formulae as follows:

For an individual: ETR = Total Tax ÷ Taxable Income

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

The effective tax rate normally relates exclusively to federal income taxes and excludes state and local income taxes, sales taxes, property taxes, and other forms of taxes that a person may pay. Individuals may calculate their overall effective tax rate by adding their entire tax burden and dividing it by their taxable income. This computation may be helpful when comparing the effective tax rates of two or more persons, or when determining what a specific individual could pay in taxes if they lived in a high-tax vs. a low-tax state—a factor for many people considering migrating in retirement.

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Investors may use a company’s effective tax rate as a profitability indicator, although it may be difficult to establish the cause of year-to-year swings in the ETR.

Marginal vs. Effective Tax Rate

The effective tax rate, which is often lower, is a more realistic portrayal of a person’s or corporation’s entire tax burden than the marginal tax rate. Remember that when comparing a marginal versus an effective tax rate, the marginal tax rate refers to the highest tax band into which their income falls.

Income is taxed at different rates that climb when income exceeds specified thresholds under a graduated or progressive income-tax system, such as the one used in the United States. Two people or businesses with the same highest marginal tax bracket may wind up with substantially different effective tax rates, depending on how much of their income was in the top bracket.

Example of an Effective Tax Rate

Consider a progressive tax system in which earnings under $100,000 are taxed at 10%, earnings between $100,000 and $300,000 are taxed at 15%, and earnings exceeding $300,000 are taxed at 25%. Consider two persons who both fell into the 25% tax bracket, despite the fact that one had a taxable income of $500,000 and the other had a taxable income of $360,000.

Both people would pay 10% of their first $100,000 in earnings, or $10,000. Both would then pay 15% of their earnings between $100,000 and $300,000, or $30,000 (15% of $200,000).

Finally, each would pay 25% of their incomes over $300,000 in taxes. That would be $15,000 (25% of $360,000) for the person with $360,000 in taxable income. However, for a person with $500,000 in taxable income, the tax would be $50,000 (25% of $200,000). Their combined tax liabilities would be $55,000 and $90,000, respectively.

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While both individuals could 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).

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