Effective Tax Rate: How It’s Calculated and How It Works

What the effective tax rate is

The effective tax rate is the average percentage of income that an individual or a corporation actually pays in income taxes. It reflects total tax paid divided by the income base (taxable income for individuals; pre-tax earnings for corporations) and is usually lower than the marginal tax rate because income is taxed at graduated rates.

Key takeaways

• The effective tax rate shows the average tax burden as a percentage of income.
• For individuals, it generally refers to federal income tax and excludes sales, property, and most state/local taxes unless explicitly included.
• For corporations, it measures tax expense as a share of pre-tax profits.
• Effective rate = total tax ÷ relevant income; multiply by 100 to express as a percentage.
• The marginal tax rate is the rate applied to the last dollar earned; the effective rate averages all rates paid.

How to calculate

Individual:
* Effective tax rate = (Total tax paid ÷ Taxable income) × 100
* You can find total tax and taxable income on your federal tax return (Form 1040).

Corporation:
* Effective corporate tax rate = (Total tax expense ÷ Earnings before taxes) × 100
* Use the company’s total tax expense from its financial statements and pre-tax income (EBT).

How it works

In a progressive (graduated) tax system, different portions of income are taxed at different rates (brackets). The marginal tax rate is the highest bracket that applies to a taxpayer’s last dollar of income. The effective tax rate averages the taxes owed across all income portions, so two taxpayers in the same marginal bracket can have different effective rates depending on the distribution of their income and deductions.

The effective tax rate typically focuses on federal income tax only. To compare total tax burdens across states or situations, include state and local taxes and divide total taxes paid by the same income base.

Example

Assume a simplified tax schedule:
* 10% on income up to $100,000
* 15% on income $100,001–$300,000
* 25% on income over $300,000

Two taxpayers:
1. Taxable income = $360,000
* 10% on first $100,000 = $10,000
* 15% on next $200,000 = $30,000
* 25% on last $60,000 = $15,000
* Total tax = $55,000
* Effective tax rate = $55,000 ÷ $360,000 ≈ 15.3%

1. Taxable income = $500,000
2. 10% on first $100,000 = $10,000
3. 15% on next $200,000 = $30,000
4. 25% on last $200,000 = $50,000
5. Total tax = $90,000
6. Effective tax rate = $90,000 ÷ $500,000 = 18%

Both are in the 25% marginal bracket, but their effective rates differ because only the income above $300,000 is taxed at 25%.

Frequently asked questions

Q: How do I find the numbers to calculate my effective tax rate?
A: On a federal return, use your total tax paid and your taxable income (both appear on Form 1040). For corporations, use total tax expense and earnings before taxes (EBT) from financial statements.

Q: Which is more relevant: effective or marginal tax rate?
A: It depends. Marginal rate matters for decisions about earning or deducting an additional dollar (tax planning). Effective rate is better for understanding overall tax burden or comparing taxpayers.

Q: Is the effective tax rate always lower than the marginal rate?
A: Yes, because the marginal rate applies only to the top portion of income, while the effective rate averages taxes across all income layers.

Bottom line

The effective tax rate is a practical measure of the average tax burden—useful for comparing tax impacts, evaluating corporate profitability after taxes, and personal financial planning. Calculate it by dividing total tax paid by the relevant income base, and consult a tax professional for personalized advice or complex situations.