Understanding Tax Terminology: Tax Rates

In the previous article, we discussed about how tax base calculations work. However, tax base calculations are just one part of the story. The other part of the calculation is the tax rate. Tax base and tax rate are multiplied to arrive at the tax amount owed by the organization.

In this article, we will understand more about what a tax rate is and how it affects the calculation of taxes payable.

What is a Tax Rate?

The first step in calculating income taxes is finding out the tax base. This tax rate is used to perform a calculation on the tax base and derive the amount payable.

Many types of taxes do not have a single rate. Instead, there are multiple rates that increase as the tax base increases. In taxation parlance, this is called a graduated structure. Income taxes generally follow a graduated structure. This is done in order to ensure that the tax system does not disproportionately harm the lower-income groups. It follows the principle of progressive taxation i.e., people with higher income should pay a higher percentage of their income as taxes.

Also, just like the tax base, tax rates can also be of different types.

Types of Tax Rates

1. Percentage Based: The most common type of tax rates are percentage-based. These rates are widely used in transactions such as income tax property tax etc. These tax rates are value-based i.e., the amount of tax collected increases as the value increases. Hence, they are called “ad valorem” rates. These rates are applied to “ad valorem” taxes.

2. Per Unit Based: However, all tax rates are not expressed in terms of percentages. There are some tax rates which are expressed on a per-unit basis also. Just like quantity-based tax bases, these rates also tend to increase with the increase in the quantity of output. The value of the products in consideration is often immaterial.

Why can Tax Rates not be Compared?

Often times, we see people comparing the tax rates between states. For instance, comparisons are often drawn between tax rates of Washington and California based on their tax rates. However, such comparisons are invalid since the tax bases can be different.

As mentioned earlier, tax rates are only used after arriving at the tax base. It is quite possible that one state allows more deductions than the other. Hence, the same nominal income will result in different tax bases in different states. The tax rate will be applied to the tax base and not to the entire income.

Because of the differences in the tax base, it is possible that a state which levies 20% tax with deductions may actually collect less than a state which levies a 15% flat tax.

The Concept of Effective Tax Rates

In the above example, the 20% and 15% tax rates are called nominal tax rates. Nominal tax rates do not provide the complete picture. Hence, in order to actually draw a comparison between two states, corporations use something called the effective tax rate.

In order to compute the effective tax rate, one additional step needs to be followed. First, the tax base needs to be determined from the total income. The second step involves multiplying the tax base with the tax rate to find the total tax payable. The third and additional step involves comparing the tax calculated with the nominal income. This number is often expressed as a percentage and provides a better view of the actual percentage of income, which is taxed.

Example of Effective Tax Rates

The concept of effective tax rates is best understood with the help of an example. Let’s assume that a corporation earns $100 in state A. As per the rules of the state, the corporations are allowed to claim various deductions, which reduce the tax base to $60. Now, the tax rate in this state is 15%. Hence, the actual amount of tax paid is 15% of $60, which is $9.

The effective tax rate compares the $9 tax paid with the actual $100 income earned to provide the tax rate, which is actually applicable to the organization. In this case, the effective tax rate applicable to the organization is 9%, even though the tax rate is 15%.

An effective tax rate provides a clearer picture of what a corporation is paying. The calculation of the effective tax rate is generally done by corporations before they decide to invest in a particular state.

In the above example, the calculation of effective tax rates was fairly simple. However, in real life, corporations have to pay a wide variety of taxes to municipal, state as well as national authorities. Each of these authorities has a different tax base, as well as the tax rate. Hence, finding the effective tax rate can be a complex task in such cases.

Finally, it needs to be understood that the nominal tax rate is applicable to everyone. However, depending upon the deductions and credits which an organization can claim, the effective tax rate can be different for different people even though the nominal rate is the same.