Effective Tax Rate

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What is Effective Tax Rate?

The effective tax rate is the rate which would be paid by a taxpayer on his tax if it was charged at a constant rate rather than progressive. Putting it other way, the effective tax rate is the average rate at which a business or individual is taxed on the earned income. It is calculated as the total tax paid divided by the taxable income. Investopedia explains effective tax rate as the net rate paid by a taxpayer if all forms of taxes are included.

Formulas for effective tax rate

The effective tax rate for an individual is calculated as:

Total Expense / Taxable Income

The effective tax rate for a Corporation is calculated as:

Total Tax Expense / Earnings before Taxes

The working of effective tax rate

The effective tax rate simplifies comparisons among companies and taxpayers. This is particularly true at places where a tiered or progressive tax system occurs. Those who are subject to progressive taxes will experience different levels of incomes being taxed at different rates.

How is Effective Tax Rate calculated?

The effective tax rate is a perfect method for how much tax should be paid in comparison to what is being earned as it is really difficult to determine the amount of income being taxed.

The key steps involved in calculating the effective tax rate are:

  • Estimate the pretax income, counting everything that is reported on for taxation. For example, rents received, wages, taxable and non-taxable interest, and capital gains recognized. Employer contributions like employment tax and contributions to retirement plans are also counted. For your advantage, also ask for a complete listing of all the personal taxes and benefits paid by the employer.
  • Also determine the income which has been earned from some other sources. Generally, these include subsidies provided by the government.
  • Estimate your comprehensive income as the sum of your pretax cash income and all income from other sources.
  • Calculate the amount paid as taxes. This amount shows how much you have owed in income taxes for the year.
  • Divide the paid taxes by the comprehensive income and multiply the resulting number with 100 thereby obtaining the percentage of income paid by you in federal taxes. 

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