Effective Tax Rate
Effective income tax rate is the ratio of income tax to total income. In case of an individual, it is calculated by dividing tax payable by total income and in case of a corporation, it is calculated by dividing total income tax expense by the earnings before income taxes.
Effective tax rate is different from the statutory tax rate and marginal tax rate. The statutory tax rate represents dollars of tax levied per $100 of taxable income. The marginal tax rate is the tax rate that applies to each additional dollar of income earned. In many cases, income tax is progressive in nature which means a person’s income is divided into different slabs and higher slab carries a relatively higher tax rate. In such a scenario, the marginal tax rate is the rate that applies to the highest income slab.
Individual effective tax rate
In many tax jurisdictions, an individual’s income is divided in accordance with tax brackets and each bracket is taxed at a different rate. The tax rate applicable to each higher bracket is higher than the preceding tax bracket.
Following is an extract from US individual tax brackets:
| Tax rate | Single |
|---|---|
| 10% | Up to $9,325 |
| 15% | $9,326 to $37,950 |
| 25% | $37,951 to $91,900 |
| 28% | $91,901 to $191,650 |
| 33% | $191,651 to $416,700 |
| 35% | $416,701 to $418,400 |
| 39.6% | $418,401 or more |
Mark is a single software engineer. His annual income is $120,000 and tax exemptions and adjustments available to him sum up to $25,000. Let’s calculate his effective tax rate.
First, we need to determine the taxable income. In this case it equals $95,000 (i.e. $120,000 minus $25,000). Next, we need to find out income tax liability.
| Bracket | Tax rate | Lower Limit | Upper Limit | Mark's Income | Tax Payable |
|---|---|---|---|---|---|
| 1 | 10% | - | 9,325 | 9,325 | 933 |
| 2 | 15% | 9,326 | 37,950 | 28,625 | 4,294 |
| 3 | 25% | 37,951 | 91,900 | 53,950 | 13,488 |
| 4 | 28% | 91,901 | 191,650 | 3,100 | 868 |
| Total | 95,000 | 19,582 |
Mark’s effective tax rate equals tax payable divided by total income:
$$ \text{Effective tax rate}=\frac{\text{\$19,582}}{\text{\$120,000}}=\text{16.32%} $$
In the above case, the tax rate applicable to each bracket is the statutory tax rate, the tax rate applicable to the highest bracket i.e. 28% is the marginal tax rate. You can see that the effective tax rate is lower than the marginal tax rate but higher than the lowest bracket income tax. The difference exists due to progressive nature of taxation and exemption of certain income.
Corporate effective income tax rate
The corporate effective income tax rate is the ratio of income tax expense (both current and deferred tax) to the earnings before income taxes (EBT).
$$ \text{Corporate effective income tax rate}=\frac{\text{IT}}{\text{EBT}} $$
The following is an extract from financial statements of The Boeing Company showing calculation of its effective income tax rate:
| USD in million | Calculation | 2015 | 2014 | 2013 |
|---|---|---|---|---|
| Current tax expense | CT | 2,245 | 836 | 5 |
| Deferred tax expense | DT | (266) | 855 | 1,641 |
| Total income tax expense | TT | 1,979 | 1,691 | 1,646 |
| Earnings before income taxes | EBT | 7,155 | 7,137 | 6,232 |
| Effective income tax rate | ‘E=TT/EBT | 27.7% | 23.7% | 26.4% |
by Obaidullah Jan, ACA, CFA and last modified on