Effective Tax Rate Calculation
The effective tax rate is important because it shows the percentage of tax an individual or company is paying on its taxable income. Knowing the percentage that you are paying can help you understand what percent of your income is really going to taxes. Knowing the percentage a company is paying can assist in determining how good an investment the company is. It differs from marginal tax rate because effective tax rate is the average percentage paid on all income rather than the percentage of tax paid on the last dollar earned.
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Personal Effective Tax Rate
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Your personal effective tax rate is calculated by dividing your total tax paid by your taxable income. When calculating your total income, include all the money that you made during the year that is subject to taxes but do not take any deductions. For example, if you made $40,000 but were able to take a deduction of $7,000 for your home mortgage, you would still use $40,000 for your income. Your total tax includes any tax, paid such as federal income tax and state income tax. If you paid $6,500 in federal taxes and $1,500 in state income taxes, your total tax would be $8,000. Dividing $8,000 by $40,000 gives you and effective tax rate of 20%.
Corporate Effective Tax Rate
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Calculating the effective tax rate of a company can be harder because taxable income is not always disclosed in annual reports. Pre-tax income can be used instead of taxable income. You can find the pre-tax income on the income statement and the amount of taxes paid in the cash flow statement. For example if you found that the pre-tax income was $2,000,000 and the taxes paid were $500,000, the effective tax rate would be 25%.
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Why Corporate Effective Tax Rates Are Important
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When making an investment in a company, investors want to make sure the company is well managed. Because the differences between effective tax rates of companies of equal size that perform similar functions in the same geographical region are generally due to managerial decisions, a company with the lower effective tax rate could have the better administration and therefore be a better investment.
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