Effective Tax Rate Formula

Effective Tax Rate Formula (Table of Contents)

Effective Tax Rate Formula
Examples of Effective Tax Rate Formula (With Excel Template)
Effective Tax Rate Formula Calculator

In a very simple language, the effective tax rate is the average rate of tax at which the income of a corporation or an individual is taxed. In the case of an individual, it can be calculated by taking a ratio of total tax expenses and taxable income and for corporations, it is calculated by dividing total income tax expense by the earnings before taxes. We should always keep in mind that the effective tax rate is not the same as the statutory tax rate or the marginal tax rate. The statutory tax rate is the dollars amount of tax levied per $100 of taxable income. On the other hand, the marginal tax rate is the rate that is applicable to additional income earned. Generally, income tax is progressive in nature. Which implies that the income is segregated into slabs and higher income slab will carry higher tax rate and vice versa. So all the income will not be taxed at the same rate and we can see what the effective tax rate is by dividing the total tax with total taxable income.

Formula For Effective Tax Rate :

Effective Tax Rate for Individual = Total Tax Expenses / Taxable Income

Effective Tax Rate for Corporation = Total Tax Expenses / Earnings Before Taxes

Examples of Effective Tax Rate Formula (With Excel Template)

Let’s take an example to understand the calculation of Effective Tax Rate in a better manner.

Effective Tax Rate Formula – Example #1

In many countries, an individual’s income is divided into tax brackets and each bracket is taxed at a different rate. Let’s take an example of Tax calculation in the US for individuals.

You can download this Effective Tax Rate Template here – Effective Tax Rate Template

Following are the tax brackets for a single individual:

Let’s say Antony is a financial analyst. His annual income is $100,000 and he put some of his income in tax savings financial instruments. Let assume that amount to be $20,000. So his taxable income is $80,000.

Since the lower limit is zero so the value of Taxable Income will be 9,325 i.e. upper limit.

Calculation of 2nd Tax Bracket:

Similarly, we will calculate the taxable income for the 3rd bracket.

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To find his effective tax rate, we need to find the tax expenses based on the above brackets.

Similarly, calculate Tax Expense for other brackets.

Then we have calculated the total of Antony’s Taxable income and a total of tax expense as follows,

Effective Tax Rate is calculated using the formula given below

Effective Tax Rate = Total Tax Expenses / Taxable Income

Effective Tax Rate = 15,738.75 / 80,000
Effective Tax Rate = 19.67%

If you see closely, you will get to know the difference is all the three tax rates. The tax rate on every bracket is the statutory tax rate. The incremental tax rate (15% on 28,625 and 25% on 42,050) is basically the marginal tax rate. So we can see that the effective tax rate is lower than the marginal tax rate but higher than the lowest bracket income tax. The reason for that is the progressive nature of taxation.

Effective Tax Rate Formula – Example #2

Below is the extract of Amazon’s financial statements to calculate the effective tax rate for a corporation.

Source: https://in.finance.yahoo.com/quote/AMZN/financials?p=AMZN

Solution:

Effective Tax Rate is calculated using the formula given below

Effective Tax Rate = Total Tax Expenses / Earnings Before Taxes

For 2018

Effective Tax Rate = 1,197,000 / 11,270,000
Effective Tax Rate = 10.6%

For 2017

Effective Tax Rate = 769,000 / 3,802,000
Effective Tax Rate = 20.2%

Explanation

Because of the progressive tax system, all the income will not be taxed at the same rate. So individuals and companies will pay different tax for a different level of income. Effective tax rate helps us in comparing companies and taxpayers. For individuals, they might not have much leeway to decrease their effective tax rates, but for corporations, it plays a vital role and they take various measure to reduce that amount.

Every business has a unique structure, business plan, circumstances, and tax implications. Because of which, every company has a different effective tax rate which it pays. For example, companies who are not doing well and had experienced financial losses in the past, they can use their losses to decrease their taxable income. Also, for research and development costs, there are tax breaks from the government which can affect not only net income but applicable income tax rates. Similarly, corporations with operations in different countries, they may strategically choose to expand operations in those countries where the tax rates are most favorable. So in a way, they will reduce their tax amount which otherwise they have to pay if they have not chosen that country.

Relevance and Uses of Effective Tax Rate Formula

The effective tax rate is one of the measures which investors use as a profitability indicator for a company. This value can change in any direction and sometimes the changes are very drastic. But it cannot be interpreted immediately why it has happened. Sometimes this happens due to operational efficiencies or limitations. But sometimes companies can indulge in activities like asset manipulation so that they can reduce their tax burden. So one should keep a close eye on that.

It can also help us in comparing the actual tax liability of the company. For example, Let say there are 2 companies A & B who are in the same bracket of a marginal tax rate of 25%. But this will not give us a clear picture of the tax exposure of these businesses. We need to see what the effective tax rate is and then compare. So if company B has more money which is taxed at 25% than A, it will have to pay a higher effective tax rate compared to A. So if we say effective tax rate of company A is 18.5% and B is 21.3%, this will be a more accurate reflection of a company’s tax liability.