The effective tax rate is the average tax rate that a tax payer was effectively assessed in a given year.
The progressive tax system we use in the United States means that every dollar is taxed differently. While the marginal tax rate can be useful in determining how much a tax payer spends on the next dollar they earn, the effective tax rate is useful for determining how much of a tax payer’s income went to pay income taxes in that year.
For example, if John Doe files as single and made $50,000 in 2015, he would have paid:
- 10% in taxes on the first $9,225 ($922.50)
- 15% in taxes on the next $28,225 ($4,233.75)
- And 25% in taxes on the last $21,775 ($5,443.75)
So, John would pay ($922.50 + $4,233.75 + $5,443.75 = $10,600) on his 2015 tax return. Since John earned $50,000 in 2015 we know that his effective tax rate is ($10,600 / $50,000 = 21.2%), meaning John paid 21.2% of his income in taxes in 2015.
The effective tax rate is used by tax payers to determine how much they spent in taxes for a given year (especially by businesses, who report this information to their shareholders). It is also used by the IRS and lawmakers to judge how fair the current tax system is, and what changes if any should be made to the tax brackets.