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:

$$ Effective\ tax\ rate=\frac{$19,582}{$120,000}=16.32\% $$

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).

$$ Corporate\ effective\ income\ tax\ rate=\frac{IT}{EBT} $$

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%

Written by Obaidullah Jan, ACA, CFA and last modified on