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 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.
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.