Wall Street Prep

Modeling effective vs marginal tax rates

Q: Can you please explain the difference between effective tax rate and marginal tax rate?

A: 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%).  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.

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 btw 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.

A good discussion of the reasons for the differences (and practical consequences for valuation) of  marginal vs effective tax rates can be found at: http://pages.stern.nyu.edu/~adamodar/New_Home_Page/valquestions/taxrate.htm


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