Explore the key differences between effective and marginal tax rates for corporations, and understand the factors contributing to these differences. Learn how different accounting standards, tax credits, and deferring taxes can influence a company's effective tax rate.
Key Insights
- The effective tax rate for a corporation is the average rate at which its pre-tax profits are taxed, while the statutory tax rate is the legal percentage established by law.
- Effective tax rate is calculated by dividing actual taxes due (based on tax statements) by the company’s pre-tax reported income. It can differ from the marginal tax rate due to differences between pre-tax income on financial statements and taxable income on the tax return.
- Marginal tax rate refers to the tax rate applied to the last dollar of a company’s taxable income, based on the statutory tax rate of the relevant jurisdiction, partly determined by the tax bracket the company falls into.
- For US corporations, the federal corporate tax rate is 35%, but with state and local taxes added, most firms face a marginal corporate tax rate of 40% or higher.
- Differences between marginal and effective tax rates can occur due to different accounting standards for tax and reporting purposes, usage of tax credits, and deferring taxes on income to future periods.
- Examples of causes for these differences include firms using straight-line depreciation for reporting and accelerated depreciation for tax purposes, use of tax credits to reduce taxes paid, and deferring taxes on income to future periods.
| What it measures | |
|---|---|
| Marginal | Tax rate on the next dollar of income — the bracket your top dollar falls in. |
| Effective | Total tax / total income — your blended average rate across all brackets. |
The effective tax rate for a corporation is the average rate at which its pre-tax profits are taxed, while the statutory tax rate is the legal percentage established by law.
Effective tax rate is the actual taxes due (based on the tax statements) divided by the company’s pre-tax reported income. Since there is difference between pre-tax income on the financial statements, and taxable income on the tax return, thus the effective tax rate can differ from the marginal tax rate.
Marginal tax rate refers to the rate that is applied to the last dollar of a company’s taxable income, based on the statutory tax rate of the relevant jurisdiction, which is partly based on which tax bracket the company occupies.
For US corporations, the federal corporate tax rate would be 35%, with the addition of state and local taxes, most firms face a marginal corporate tax rate of 40% or higher. The reason it’s called marginal tax rate is because as you move up in tax brackets, your “marginal” income is what is taxed at the next highest bracket.
Reasons for Differences between Marginal and Effective Tax Rates
Given that most of the taxable income of publicly traded firms is at the highest marginal tax bracket, why would a firm’s effective tax rate be different from its marginal tax rate? There are at least three reasons:
- Many firms follow different accounting standards for tax and reporting purposes. For instance, firms often use straight-line depreciation for reporting purposes and accelerated depreciation for tax purposes. As a consequence, the reported income is significantly higher than the taxable income, on which taxes are based.
- Firms sometimes use tax credits to reduce the taxes they pay. These credits, in turn, can reduce the effective tax rate below the marginal tax rate.
- Finally, firms can sometimes defer taxes on income to future periods. If firms defer taxes, the taxes paid in the current period will be at a rate lower than the marginal tax rate. In a later period, however, when the firm pays the deferred taxes, the effective tax rate will be higher than the marginal tax rate.
