Multiple tax rates apply to a company. Federal /state statutory tax rates, Effective tax rates, marginal tax rates, etc.
- Federal /State Statutory Tax Rate: Every country and state that a company is domiciled in has a tax rates prescribed by law. In most countries, different tax rates apply based on the level of income or size of the company, type of income, etc.
- Effective Tax Rate: Effective tax rate is the tax expense divided by the pretax income of a specific year. The taxes expense of a company is arrived at according to the statutory tax rates and tax slabs applicable to the company. If the company earns income from multiple countries, multiple statutory tax rates and tax slabs will apply to different portions of income according to local laws and intercountry tax agreements such as double tax avoidance agreements.
- Marginal Tax Rate: The marginal tax rate is the tax rate applicable to the last dollar (marginal income). This marginal tax rate is usually the tax rate applicable to the highest slab that applies to the tax-payer.
There is no one size fits all tax rate that is best when valuing a company using the DCF valuation approach. On this page, we address the question: What are the drawbacks of using an effective tax rate in forecasting cash flows?
The effective tax rate is usually lower (not always) than the marginal tax rate. So, if you use the effective tax rate for the entire DCF model, you are likely over-reporting your after-tax cash flows.
The effective tax rate is usually lower than the marginal tax rate due to the following reasons:
- In a progressive tax system, the tax rates increase as your income moves higher.
- The marginal tax rate which is the tax rate applicable on the last dollar of income is applicable only on the income at the highest tax slab. Other income is taxed at lower rates.
- The income tax code in different countries allow a number of deductions in taxable income.
- Some income is exempt from tax altogether (for example muni bond interest) and some income has specified tax rates (such as long-term capital gains or royalties).
Remember that there is no one size fits all tax rate that is best when valuing a company using the DCF valuation approach. Please read about the drawbacks of using the marginal tax rates in doing a DCF valuation here.