What's effective tax rate? Is it better if a company has a high or a low % of effective tax rate?

Answer 1

Lower, obviously! The less tax paid, the more money for the owners.

Answer 2

Actually, the effective tax rate is the percentage derived by dividing (1) income tax expense allocated to continuing operations by (2) pre-tax income from continuing operations.

Income tax expense is generally not the same as the amount of tax actually paid. The reason is that income tax expense is determined based on GAAP (FAS109 in particular) and tax paid is based on the IRC.

What might help you understand the difference between the effective tax rate and the actual tax rate (i.e., the statutory tax rate) is if you look at the income tax footnote of any company's 10-k. The footnote is required to disclose a reconciliation between the statutory rate (normally 35%) and the effective tax rate - this will show you the things that cause the statutory rate and the effective tax rates to differ.

Answer 3

Sorry bosto...I beg to differ. The effective tax rate is the rate that is calculated by taking your total taxes paid per your income statement and dividing by your pretax income. This would then include any federal and state income taxes.

The higher effective tax rate, the higher the income being earned. As such, a lower tax rate may not be better for the owners. Obviously a company would want to minimize tax liability, however, not at the cost of profits.

Hypothetical situation:

Your company makes $1 million in pretax profits. Your effective tax rate may be 18%. Your after tax profit would be $820,000.

Ok, say your company made $2,000,000 in pretax. Same effective tax rate. Your after tax profit is now $1,300,000.

Which would you rather have. Just because situation 1 has a lower effective tax rate doesnt mean it is better.