What Is the Effective Tax Rate?
The effective tax rate refers to the percentage of an individual’s or corporation’s income paid in taxes. For individuals, it is the average rate at which their income—both earned such as wages, and unearned like stock dividends—is taxed. For corporations, it indicates the average rate at which their pre-tax profits are taxed, distinct from the statutory tax rate which is set by law.
Key Insights
- Effective Tax Rate: The overall percentage of taxable income that individuals and corporations pay in taxes.
- Individual Taxes: Reflect the rates as income crosses various thresholds under marginal tax systems.
- Corporate Taxes: The rate applied to a company’s pre-tax profits.
- Overall Tax Burden: Captures the total tax obligations including state, local, sales, and property taxes besides federal taxes.
- Marginal vs Effective: Marginal tax rate refers to the highest rate applied to income whereas effective tax rate offers an average view.
How to Calculate the Effective Tax Rate
Calculating the effective tax rate can be straightforward when using the correct formula. Here are the formulas for individuals and corporations:
| —————–|———————————————– | | Individual | ETR = Total Tax / Taxable Income | | Corporation | ETR = Total Tax / Earnings Before Taxes |
For a quick example,
- Individuals: Refer to Form 1040. Divide the total tax (Line 24) by taxable income (Line 15) and multiply by 100.
- Corporations: Divide the total tax expenses by earnings before tax.
The Role of the Effective Tax Rate
The effective tax rate is essential as it calculates the average tax paid by individuals or corporations relative to their income. Typically, it focuses on federal income taxes, not accounting for other types of taxes such as:
- State and local income taxes
- Sales taxes
- Property taxes
- Additional taxes relevant to individuals
By summing up the total tax burden and comparing it against taxable income, it helps individuals consider the practical implications on relocation, especially in high vs. low tax states during retirement.
Investors also look at the effective tax rate to gauge a company’s profitability, considering this rate may fluctuate year-to-year.
Effective Tax Rate vs. Marginal Tax Rate
The effective tax rate gives a full picture of a tax entity’s liability in contrast to the marginal tax rate — the maximum rate of income tax applied as income increases. In a progressive tax system like in the U.S., different income levels are taxed at varying rates, yielding different effective tax rates for entities within the same upper tax bracket.
Federal Tax Brackets
U.S. federal tax brackets determine the tax rates for various income levels, overseen by the IRS.
| Federal Tax Brackets (2023) | |||||
|---|---|---|---|---|---|
| 10% | $0 to $11,000 | $0 to $11,000 | $0 to $22,000 | $0 to $22,000 | $0 to $15,700 |
| 12% | $11,000 to $44,725 | $11,000 to $44,725 | $22,000 to $89,450 | $22,000 to $89,450 | $15,700 to $59,850 |
| 22% | $44,725 to $95,375 | $44,725 to $95,375 | $89,450 to $190,750 | $89,450 to $190,750 | $59,850 to $95,350 |
| 24% | $95,375 to $182,100 | $95,375 to $182,100 | $190,750 to $364,200 | $190,750 to $364,200 | $95,350 to $182,100 |
| 32% | $182,100 to $231,250 | $182,100 to $231,250 | $364,200 to $462,500 | $364,200 to $462,500 | $182,100 to $231,250 |
| 35% | $231,250 to $578,125 | $231,250 to $346,875 | $462,500 to $693,750 | $462,500 to $693,750 | $231,250 to $578,100 |
| 37% | $578,125 or more | $346,875 or more | $693,750 or more | $693,750 or more | $578,100 or more |
Example of Effective Tax Rate Calculation
Let’s take a sample graduated tax system: income up to $100,000 taxed at 10%, income between $100,000 to $300,000 taxed at 15%, and over $300,000 taxed at 25%. Considering two taxpayers hitting the upper tax bracket:
- Taxpayer A: Taxable income of $500,000.
- Taxpayer B: Taxable income of $360,000.
Here’s how their taxes would compare:
- Income $100,000 @ 10% - Both pay $10,000.
- Income $100,000 - $300,000 @ 15% - Both pay $30,000.
- Income $300,000+ ($60,000 and $200,000 respectively) @ 25% - $15,000 for B and $50,000 for A.
- Total tax: $55,000 for B with effective rate of 15.3% ($55,000 / $360,000), and $90,000 for A with effective rate of 18% ($90,000 / $500,000).
Computing Your Effective Tax Rate
You can calculate your effective tax rate by dividing your total tax (Line 24, Form 1040) by your taxable income (Line 15, Form 1040), then multiplying the quotient by 100.
Analyzing Effective vs. Marginal Tax Rate
- Effective Tax Rate: The blended annual rate of tax without considering income strata.
- Marginal Tax Rate: Incremental tax level increases with income, got taxed more progressively.
Which is Lower?
Your effective tax rate usually lies lower as the marginal rate depends on the income slab divisions treated progressively.
Final Thoughts
Your effective tax rate is a crucial marker, making federal tax classification simpler through IRS-regulated brackets. Entrepreneurs and individuals should be assured yet diligent for full disclosures, verified professional assistance, and accurately filed returns to leverage transparent finances.
Related Terms: earned income, unearned income, tax brackets, sales tax, property tax, retirement income.
References
- Internal Revenue Service. “Form 1940: U.S. Individual Income Tax Return”, Pages 1-2.
