Work out the effective, statutory and cash rates of tax and contrast them
The idea
Three tax rates tell different stories. The statutory rate is the rate set in law. The effective tax rate is income tax expense divided by pre-tax income, and it departs from the statutory rate because of foreign earnings taxed at different rates, tax-exempt income, credits and non-deductible expenses; the reconciliation in the tax note explains each difference. The cash tax rate is cash taxes paid divided by pre-tax income, and it differs from the effective rate because of deferred taxes: accelerated tax depreciation, for instance, pushes cash taxes below the expense and builds a deferred tax liability. For forecasting, the analyst asks which differences will persist. A low effective rate driven by a one-off credit should not be projected forward, and a cash rate persistently below the effective rate may reverse if investment slows.
A practice question
A company's effective tax rate is calculated as:
- cash taxes paid / pre-tax incomeWhy not: That is the cash tax rate, which differs whenever deferred taxes change.
- income tax expense / net incomeWhy not: Uses post-tax income as the base, which overstates the rate.
- income tax expense / pre-tax income — correct
The effective rate relates the tax expense on the income statement to pre-tax income; comparing it with the statutory rate shows the effect of permanent differences and foreign rates.
A harder one
A company reports pre-tax income of 800, income tax expense of 200 and cash taxes paid of 160. Its cash tax rate is:
- 25.0%Why not: Uses the tax expense (200 / 800), which is the effective rate.
- 20.0% — correct
- 80.0%Why not: Divides cash taxes by tax expense instead of by pre-tax income.
Cash tax rate = cash taxes paid / pre-tax income = 160 / 800 = 20.0%.
The hardest tier
A company's cash tax rate has been well below its effective tax rate for several years because of accelerated tax depreciation. The most appropriate conclusion is that:
- a deferred tax liability is growing — correct
- a deferred tax asset is growingWhy not: Gets the direction wrong. Paying less tax now than expensed means tax is owed later, a liability.
- the gap is certain to persistWhy not: It persists only while investment keeps growing. If capital spending slows, the difference reverses.
Cash tax below tax expense means the difference is being deferred, building a deferred tax liability. The analyst should ask whether investment will continue at a pace that keeps the gap open.
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