What is an Effective Tax Rate?

Adam Hill

An effective tax rate is the total or average income tax burden on a person or company, after all tax rates have been calculated. Tax rates can be expressed in many ways to highlight different aspects of a tax system, but the effective tax rate gives the clearest aggregate picture of a person's tax burden. Mathematically, it is calculated as the total tax paid, divided by the total taxable income, and is noted as a percentage.

The effective tax rate is the average tax a company or individual pays after all of their taxes have been calculated.
The effective tax rate is the average tax a company or individual pays after all of their taxes have been calculated.

The use of a calculation like the effective tax rate is useful for several reasons. The main one is that the Internal Revenue Code of the United States, which governs taxes, is highly complex. It was not always necessary to consult a qualified accountant when preparing tax returns, but this is increasingly the case. In the whirlwind of deductions, withholding, credits, and other complications, it can often be difficult to determine exactly how much income tax you are paying as a percentage of total taxable income.

Those who make more than $100,000 in the US must forego tax tables and calculate their income tax.
Those who make more than $100,000 in the US must forego tax tables and calculate their income tax.

Especially in the case of so-called "progressive" or tiered tax systems, it is easy to lose track of one's actual tax rate. Consider the following hypothetical situation. In a certain progressive tax system, the first $50,000 U.S. Dollars (USD) of a person's income are taxed at a ten percent rate. The next $100,000 USD are taxed at 25%, and anything remaining over that is taxed at 35%.

If a person pays the required taxes on all of his $217,950 USD of income, it would be easy for that person to not know how much his effective tax rate was. A few simple calculations are necessary to show that it is approximately 24.6%. This percentage will be slightly different for every income level because of the tiered structure of the system.

Apart from the simple effective tax rate, there are a few variations on this expression that can also be useful. For instance, the marginal effective tax rate is a combination of the marginal and the effective tax rate, and is used to calculate the total tax rate imposed on the last, or marginal, dollar that is spent or earned. The effective average tax rate is another variation, and may be different from the effective tax rate if it is calculated using some other measure than taxable income. While the many different ways to express tax rates may sometimes seem to lead to further confusion, such calculations are helpful, if nothing else to determine when unintended of unfair consequences of the tax code may occur.

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Discussion Comments


Does anyone have any idea how taxes work in other countries? I know a lot of people complain about the United States' tax system. I just wonder if other countries pay more or less in taxes than Americans do.

The one case that I am somewhat familiar with is England's value added tax. I don't remember if that is the exact name, but it is something along those lines. Basically, it is a sales tax rate that is applied to anything you buy that meets certain criteria. When I visited a few years ago, almost everything had some sort of tax applied to it. The taxes were kind of steep, too, if I remember correctly.

I guess my point is that other countries oftentimes pay the same or more in taxes than people pay in America, they just might come from different places. That being said, I am not sure if other places have things like state or province tax rates or the like. I think that would be something interesting to know.


@titans62 - To add a bit to your comment, one of the things that also comes into play when figuring your effective tax rate is paying capital gains tax. Capital gains are earnings you get from selling stocks and other investments. One of the main arguments is that the capital gains tax is too low, which helps wealthier individuals who actually have more money to invest in the first place.

What I am curious about is whether anyone has any information about how the effective tax rates have changed throughout history. That is something that I don't think gets mentioned very much. I know income tax is a relatively new thing in America. I believe I remember hearing a couple weeks ago that it wasn't until after World War II that all Americans started getting taxed. I just wonder if there are some ideas that we can take from the past that might be helpful for the future.


@stl156 - Good questions. One thing to remember is that there is a difference in the marginal tax rate vs effective tax rate. Marginal tax rate is, by definition, the tax on the last dollar you earn. That is where the differences between a progressive and flat tax system come into play. With a progressive tax, like the article shows, your last dollar may be taxed higher than your first dollar depending on your income. With a flat tax, every dollar is theoretically taxed at the same rate. The effective rate is the average tax per each dollar at the end.

Most of the flat tax plans put the proposed rate somewhere around 20 percent. The reasoning behind this is that people who make more money shouldn't have to pay more in taxes because they earned the money, and everyone should be taxed equally.

I think you hit the nail on the head saying that no matter what system is in place, some people will be unhappy. I think with any system there is still going to be a big market for tax help professionals.


So, as I understand it, the United States has a progressive tax system, correct? What are the benefits of having a system like this compared to a flat tax rate or some other system? I know it is usually a hotly contested election issue. I especially remember all the candidates talking about the different tax systems for the 2008 election.

If one of the other systems is so much better, why aren't we using it instead? It seems like no matter what system is in place, people will always find a way to complain about it. I'm not much for economics, though, and have trouble even filling out simple tax forms, so I guess this kind of stuff isn't really my specialty. I suppose, then, what I am really wondering in this whole thing is what the different effective tax rates really mean in the long run.

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