Effective tax rate
AccountingThe reported tax charge divided by pre tax profit, a book measure of what the accounts recorded rather than what was paid.
Also written: ETR, book effective tax rate, reported tax rate
The effective rate is an output of the accounts rather than a rate anyone chose. It is the total tax charge, current plus deferred, divided by pre tax profit, and it answers what the income statement recorded for the year.
It diverges from the statutory rate for reasons that are worth being able to name: profit earned in countries with different rates, expenses that are not deductible, income that is not taxable, prior year adjustments, changes in the recognition of deferred tax assets, and one off settlements.
In a DCF it is dangerous in two ways at once. It is struck after interest, so it already contains the tax shield that WACC also contains, and it is distorted by items that will not repeat. Lifting it out of last year's accounts imports both problems without either being visible in the model.
It is still worth calculating. A persistent gap between the effective rate and the statutory rate is information: it points to where profit is being earned, or to a structural feature such as a patent box regime, and that is exactly the case where a normalised effective rate may be the better forecast assumption.
Worked example
A company reports pre tax profit of 340 and a total tax charge of 61, so an effective rate of 17.9% against a 25% statutory rate.
The notes reconcile the 24 gap to the statutory charge of 85: a 20 release of a prior year provision, with the remaining 4 from income that is permanently not taxable. Strip the release and the underlying rate is about 23.8%.
Forecasting at 17.9% would carry a one off release into perpetuity. Forecasting at 25% would ignore a permanent feature. The defensible answer sits between the two and gets stated as an assumption.