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Marginal v. Effective Tax Rate

Marginal vs Effective Tax

FeatureWhat it measures
MarginalTax rate on the next dollar of income — the bracket your top dollar falls in.
EffectiveTotal tax / total income — your blended average rate across all brackets.
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Understand the difference between the effective and marginal tax rates for corporations, and explore the reasons for the discrepancy between these two rates.

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:

  1. 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.
  2. 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.
  3. 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.