Effective, statutory and cash tax rates

Which tax rates matter to an analyst?

Three. The statutory tax rate is the corporate income tax rate in the country where the company is domiciled. The effective tax rate is what the company actually bears on its reported profit. The cash tax rate is what it actually pays in cash.

Tax rates an analyst uses

• Statutory rate Memorize headline corporate rate where the company is domiciled: the benchmark
• Effective rate Memorize income tax expense ÷ pretax income: forecast earnings with it
• Cash tax rate Memorize cash taxes ÷ pretax income: forecast cash flow with it

$$ETR = \frac{\text{income tax expense}}{\text{pretax income}}$$

$$CTR = \frac{\text{cash taxes paid}}{\text{pretax income}}$$

Exam tip Both rates share the same denominator, pretax income. The only thing that changes is the numerator: expense for effective, cash paid for cash.

Which rate do you forecast with?

Forecast earnings with the effective rate and cash flow with the cash tax rate. The effective rate is a rate on the income statement; the cash rate belongs with the cash flow statement. The statutory rate is only the benchmark.

A model that mixes them misstates one statement. Taxes in the income statement use the effective rate; the cash taxes line in the cash flow statement (or the supplemental disclosure) uses the cash rate.

Go deeper What counts as 'cash taxes paid'

The cash tax rate uses the tax actually paid in the period, from the cash flow statement or its supplemental disclosure. Some textbook solutions use the current tax expense (the tax on this year’s taxable income) as a stand-in, because it is close to cash paid. Use whichever number the question labels as cash taxes or current tax.

Why does the effective rate move away from the statutory rate?

Anything that makes accounting profit and taxable income differ permanently, or that changes where profit is taxed, moves the ETR.

Effective rate versus statutory rate

• Pushes it up
  • Non-deductible expenses a permanent difference
  • Withholding tax on dividends
  • Profit in higher-tax countries
• Pulls it down
  • Tax-exempt income a permanent difference
  • Tax credits for example for research spending
  • Profit in lower-tax countries Use it the geographic mix of profits
• Either way
  • Adjustments to previous years
  • One-off settlements and rate changes

Permanent differences push the rate one way: non-deductible costs raise it, tax-exempt income lowers it. Tax credits lower it. And the mix of countries matters. The geographic mix of profits makes the effective rate a weighted blend of the local rates, weighted by profit. Because the weights are profit shares, the blend is higher than the simple average of the rates when most of the profit is earned in the high-tax country.

$$ETR = \sum_i w_i \, t_i$$

Tax credits (for example for research spending) reduce the tax bill itself, so they lower the effective rate. A consistently low effective rate relative to peers is not wrong in itself, but read the reconciliation in the next lesson to see whether it will last.

Go deeper Why the cash rate can be far below the effective rate

A fast-growing, capital-intensive company deducts large accelerated depreciation for tax. Its DTL grows each year, so cash taxes stay well below the expense for as long as it keeps investing. Looking only at the effective rate would overstate its cash tax cost. Looking only at the cash rate would understate the tax it will eventually pay if growth slows.

Go deeper Normalizing the rate for a forecast

Volatile income from equity-method investees can distort the effective rate, because it is reported after tax. Many analysts compute the rate on normalized operating income, before associate results and special items, and use that for the forecast. Never forecast with a year that contains a one-off tax benefit.