Which statement correctly describes marginal tax rate (MTR) and effective tax rate (ETR)?

Which statement correctly describes marginal tax rate (MTR) and effective tax rate (ETR)?

• A. MTR is the marginal tax rate on the last dollar; ETR is tax expense divided by profit before tax
• B. MTR equals ETR
• C. MTR uses only federal rate; ETR uses state rates
• D. MTR is based on earnings; ETR is based on cash flows

Answer: (A)

The main idea here is telling apart two ways to summarize the tax burden. The marginal tax rate is the rate applied to the next dollar of taxable income—the last increment that pushes you into the current bracket. The effective tax rate is the overall tax you pay divided by your pre-tax income, giving the average rate across all earnings after accounting for deductions, credits, and the bracket structure. For corporations, the effective tax rate is usually computed as total tax expense divided by profit before tax, showing the broad burden on earnings rather than the rate on any single dollar. This makes the statement correct: the marginal rate is the tax rate on the last dollar earned, and the effective rate is tax expense divided by pre-tax income. In practice, these can differ—a company might have a high marginal rate if its last dollar falls into a higher bracket, but its average (effective) rate could be lower due to deductions or credits. The other descriptions don’t fit because marginal and effective rates are not generally the same, marginal rates aren’t limited to federal rates (state/local taxes matter in the marginal calculation), and the effective rate is not defined purely from cash flows in this context but from taxes relative to pre-tax income.

The main idea here is telling apart two ways to summarize the tax burden. The marginal tax rate is the rate applied to the next dollar of taxable income—the last increment that pushes you into the current bracket. The effective tax rate is the overall tax you pay divided by your pre-tax income, giving the average rate across all earnings after accounting for deductions, credits, and the bracket structure. For corporations, the effective tax rate is usually computed as total tax expense divided by profit before tax, showing the broad burden on earnings rather than the rate on any single dollar.

This makes the statement correct: the marginal rate is the tax rate on the last dollar earned, and the effective rate is tax expense divided by pre-tax income. In practice, these can differ—a company might have a high marginal rate if its last dollar falls into a higher bracket, but its average (effective) rate could be lower due to deductions or credits. The other descriptions don’t fit because marginal and effective rates are not generally the same, marginal rates aren’t limited to federal rates (state/local taxes matter in the marginal calculation), and the effective rate is not defined purely from cash flows in this context but from taxes relative to pre-tax income.