Effective Tax Rate

The average rate of tax payable by an organization or a person

What is the Effective Tax Rate?

The effective tax rate can be defined as an average rate of tax payable by an organization or a person. The average rate at which an individual’s earned and unearned income is taxed is known as their effective tax rate.

An individual’s earned income can be a salary or wage and their unearned income can include dividends. For organizations, the effective tax rate is the average rate at which their earnings (earnings before taxes) are taxed. The statutory tax rate, on the other hand, is laid down by law as a legal percentage.

 

Effective Tax Rate

 

Furthermore, the effective tax rate is the actual amount of federal income tax payable on a person’s income, excluding self-employment taxes, local and state taxes, and FICA taxes. The measurement of a person’s marginal tax rate can serve as a substitute to the effective tax rate; however, they are entirely different from each other.

The effective tax rate is useful when comparing the taxes paid by two separate organizations or people.

 

Summary

  • The effective tax rate can be defined as the average rate of tax payable by an organization or person. It is the actual amount of federal income tax payable on a person’s income, excluding self-employment taxes, local and state taxes, and FICA taxes.
  • For corporations, the effective tax rate can be found by dividing the tax expense by the earnings before tax of the company. The effective tax rate for individuals is found by dividing their tax expense by their taxable income.
  • The marginal tax rate is the maximum percentage of income tax that anyone is liable to pay in a system that applies tax burdens to people depending on their respective actual taxable incomes.

 

Calculating the Effective Tax Rate

For corporations, the effective tax rate can be found by dividing the tax expense by the earnings before tax of the company. The effective tax rate for individuals is found by dividing their tax expense by their taxable income.

For individuals in the U.S, their “Total Tax” and their “Taxable Income” can be found in Form 1040. The form calculates the total taxable income for an individual and estimates how much tax has to be paid or refunded by the government. It is used for filing personal federal income tax returns.

 

Effective Tax Rate - Corporation

Effective Tax Rate - Individual

 

Sample Computation

Consider the following scenario:

Individual A reports a taxable income of $450,000 and Individual X’s taxable income is $380,000.

The individuals live in a country with a tax system where:

  • Income under $100,000 is taxed at 12%;
  • Income between $100,00 and $350,000 is taxed at 18%; and
  • Income over $ 350,000 is taxed at 28%.

 

Based on the available information, both individuals fall in the 28% bracket, despite reporting different taxable incomes. It means that they would both be liable to pay the 12% for the first $100,000 tax bracket, amounting to $12,000. Additionally, they would both be liable to pay the 18% for the amount between $100,00 and $350,000 (a $250,000 difference), which is computed as 18% multiplied by $250,000, amounting to $45,000.

For the earnings over the $350,000 threshold, they are both liable for 28% on their respective earnings. For Individual A with a taxable income of $450,000, the 28% would equate to $28,000. For Individual X with the $380,00 taxable income, the tax for the said bracket would amount to $8,400.

Hence, for Individual A, the tax obligation would be $85,000, and for Individual X, the tax obligation would be $65,400. The effective tax rate for Individual A would be 18.8%, and the effective tax rate for Individual X would be 17.2%. Despite both individuals being in the 28% tax bracket, their effective tax rates are different.

 

Marginal Tax Rate

The marginal tax rate is the maximum percentage of income tax that anyone is liable to pay in a system that applies tax burdens to people depending on their respective actual taxable incomes.

 

More Resources

CFI is the official provider of the global Capital Markets & Securities Analyst (CMSA)® certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional CFI resources below will be useful:

  • Gross Income
  • How to Use the IRS.gov Website
  • Jointly and Severally
  • Progressive Tax

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