Effective Tax Rate – Definition
Effective tax rate is the average tax rate applied to a individual or corporation’s income.
Formulas for calculating an effective tax rate are as following;
For an individual: Effective tax rate = Total Tax Expense ÷ Taxable Income
For a corporation: Effective tax rate = Total Tax Expenses ÷ Earnings before Taxes
For individuals, the total tax expense (taken from line 63 of Form 1040) is divided by her taxable income from line 43.
The effective tax rate does not consist of other types of taxes such as sales tax, import or export tax, or property taxes. Sometimes analysts may include excise and other types of taxes while calculating the effective tax rate.
Effective Tax Rate vs. Marginal Tax Rate
The marginal tax rate is the rate which is applied to each additional dollar earned. Tax is levied on different income levels, and the income levels fall into different tax brackets. Marginal income taxes will can fall into the next tax bracket (the marginal rate).
Let’s assume a tax system where income tax rate is 10% for $100,000, 15% for income from $100,000 to $300,000, and 25% for income over $300,000. Assume both firms fall into the highest tax bracket. However, one firm earned $500,000, while earnings of the other firm are $360,000. Both firms has to pay 10 % or $10,000 on their $100,000 of profit, and both firms pay 15% or $30,000 on profits between $100,000 and $300,000. Both firms also pay 25% on their profits over $300,000.
But the tax for one firm is $50,000 and only $15,000 for the other firm. With a total tax of $90,000, the firm with $500,000 in sales pays an 18 percent effective tax rate, while firm with $360,000 in income pays a total income tax of $55,000, making its effective tax rate only 15.2 percent.
References for Effective Tax Rate
Academic Research on Effective Tax Rate
● Determinants of the variability in corporate effective tax rates: Evidence from longitudinal data, Gupta, S., & Newberry, K. (1997). Journal of accounting and public policy, 16(1), 1-34. This study suggests that ETRs are not associated with firm size when the relation is examined over time with firms having longer histories using data from micro-level longitudinal data spanning the Tax Reform Act of 1986 (TRA86).
● Effective tax rates in macroeconomics: Cross-country estimates of tax rates on factor incomes and consumption, Mendoza, E. G., Razin, A., & Tesar, L. L. (1994). Journal of Monetary Economics, 34(3), 297-323. This paper proposes a method for computing tax rates using national accounts and revenue statistics.
● Which effective tax rate?, Fullerton, D. (1983). This paper examines the calculation technique for an effective tax rate for capital income. This paper categorizes effective tax rates into four basic types, and it discusses eleven separate reasons to expect the effective tax on marginal investment to differ from the observed tax on the past or average investment.
● The effective tax rate and the pretax rate of return, Feldstein, M., Dicks-Mireaux, L., & Poterba, J. (1983). Journal of Public Economics, 21(2), 129-158. This paper presents new estimates of the taxes paid on nonfinancial corporate capital, on the pretax rate of return to capital, and on the effective tax rate. Using different analysis, the authors were able to conclude that the effective tax rate and the pretax rate of return move in opposite directions, with lower pretax occuring when the tax rate is higher.
● An investigation of the firm size—effective tax rate relation in the 1980s, Omer, T. C., Molloy, K. H., & Ziebart, D. A. (1993). Journal of Accounting, Auditing & Finance, 8(2), 167-182. This study investigates the relation between firm size and corporate tax burdens on a yearly and an industry basis, given effective tax rate. The analysis is conducted using five effective tax measures employed in previous studies in order to determine the degree to which inferences between size and tax burden are robust across these different effective tax measures.
● Public policy, political connections, and effective tax rates: Longitudinal evidence from Malaysia, Adhikari, A., Derashid, C., & Zhang, H. (2006). Journal of Accounting and Public policy, 25(5), 574-595. This study examines the link between effective tax rates (ETR) and political connections in developing economies.
● Determinants of the variability in corporate effective tax rates and tax reform: Evidence from Australia, Richardson, G., & Lanis, R. (2007). Journal of Accounting and Public Policy, 26(6), 689-704. This study examines the determinants of the variability in corporate effective tax rates in Australia spanning the Ralph Review of Business Taxation reform.
● Effective tax rate changes and earnings stripping following corporate inversion, Seida, J. A., & Wempe, W. F. (2004). National Tax Journal, 805-828. In this research, the authors examine the financial and valuation consequences of corporate inversion using a sample of 12 inversion firms and 24 matched firms. The main objective is to show that effective tax rates decline substantially following inversion, and that abnormal returns at shareholder approval dates are associated with inverted firms’ realized ETR changes.
● Average effective tax rates on capital, labour and consumption, Carey, D., & Tchilinguirian, H. (2000). This paper explores the impact of tax reforms on the shape of OECD tax systems, and the measurement of effective tax burdens. This paper updates and extends the Mendoza et al. estimates of average effective tax rates (AETRs) and presents new estimates based on modifications to the methodology to make some of the underlying assumptions more realistic.
● A new summary measure of the effective tax rate on investment, Gordon, R., Kalambokidis, L., & Slemrod, J. (2003). National Bureau of Economic Research. In this paper, the authors derive explicitly how revenue figures (under the existing system and under a hypothetical R-base tax) can be used to construct an estimate of the true effective tax rate on capital income, and how this measure and existing measures are affected by several factors, including resale of assets (churning), risk, pure profits, debt finance and arbitrage, and choice of organizational form.