Definition: Effective tax rate is the average percentage that companies and individuals pay in taxes on their taxable income. It’s typically calculated by dividing total taxes paid by the total taxable income. In other words, this is the rate that you are actually paying on your total income, not your marginal or bracket rate.
What Does Effective Tax Rate Mean?
What is the definition of effective tax rate? Often, the effective rate for individuals pertains only to income taxes without including other types of taxes. However, financial analysts include all sorts of taxes when calculating the burden tax on a firm, thus being able to perform a comparison between firms that operate in the same industry.
Since the tax code treats individuals and companies differently, each effective tax rate formula is slightly different. Individuals calculate their rate by dividing taxes paid by taxable income. Companies, on the other hand, typically divide their tax expenses by EBIT.
Let’s look at an example.
Example
Let’s assume the tax brackets for individuals are:
- $ 0 – $50,000 – 10%
- $50,001 – $150,000 – 15%
- $150,001 – $250,000 – 25%
- $250,001 – $500,000 – 33%
Kaleb is single, and he files his taxes as a single filer. He owns a beauty salon, and his annual income is $58,000. According to the tax brackets, Kaleb falls under both the 10 and 15 percent brackets.
Alex is also a single filer. He runs a fine-dining restaurant, and his annual income is $220,000. According to the tax brackets, Alex falls under the 10, 15, and 25 percent brackets.
What is the effective tax rate for Kaleb and what is the effective tax rate for Alex?
Kaleb’s total tax liability is $6,200 computed as follows:
- $50,000 x 10% = $5,000
- $8,000 x 15% = $1,200
Alex’s total tax liability is $32,500 computed as follows:
- $50,000 x 10% = $5,000
- $149,999 x 15% = $22,500
- $20,001 x 25% = $5,000
Here’s how to calculate effective tax rates of both.
With a total tax liability of $6,200, Kaleb pays an effective rate of 10.7% on his income of $58,000 (6,200 / 58,000).
Alex, on the other hand, has a total tax liability of $32,500 and pays an effective rate of 14.7% on his income of $220,000 (32,500 / 220,000).
As you can see, the ETR goes up as the brackets increase, but the ETR is significantly lower than the marginal rates. This is because ETR is an average of all taxes paid on total taxable income.
Summary Definition:
Define Effective Tax Rate: ETR is the average percentage of taxes you pay on your total income.
