Effective Tax Rate

Reviewed by Sweta | Updated on Jun 17, 2022



The term effective tax rate is used in the context of direct taxes or income tax. It is the average rate of tax paid by a taxpayer.

What is Effective Tax Rate?

Effective tax rate can be defined as the average rate at which an individual is taxed on earned income, or the average rate at which a corporation is taxed on pre-tax profits. The overall tax incidence under the applicable tax rates is lower due to the various allowances and deductions claimed by a taxpayer. The effective tax rate may be lower than the tax rates applicable under different slabs to an individual. Similarly, the rate can be lower due to tax deductions or incentives claimed by corporate taxpayers.

The statutory rate is the rate established by the tax laws in force in the country. However, effective tax rate is the rate at which tax is payable on the earnings from salary, property, capital gains, business or profession exercised by a taxpayer.

The effective tax rate is calculated only by taking into account the income tax liabilities including cess imposed by Central Government if any. The rate does not take into account, the state government levies or local levies such as sales tax, entertainment tax, professional tax, luxury tax, and so on.

The effective tax rate accurately represents a taxpayer’s overall tax liability in comparison to their marginal tax rate and is generally lower. While comparing the marginal versus an effective tax rate, it is essential to note that the marginal tax rate refers to the highest tax bracket into which their income falls.

How to Calculate Effective Tax Rate?

Effective tax rate is arrived at by dividing the net tax liability (including cess if any) by the net taxable income.

In the case of corporations, the effective tax rate is lower than their maximum marginal tax rate.

The formula for calculation of effective tax rate: Effective tax rate (individual) = Total tax / Taxable income Effective tax rate (corporation) = Total tax / Earnings before tax

The calculation of effective tax rate is useful for comparing the effective tax rates and earnings as between two or more countries. The tax rates and savings differ from one country to another. The same would be influenced by the tax policy of the government.

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