The effective tax rate is the actual percentage of your total income that you pay in taxes. It is determined after accounting for deductions, exemptions, credits, and additional levies such as cess. You can make more informed decisions about your tax responsibilities and improve your financial planning by knowing how it is calculated.
In this blog, we shall understand the meaning of the effective tax rate, how to compute it, along with real-world examples.
Meaning of Effective Tax Rate
The effective tax rate is the ratio of total tax paid to an individual’s income, commonly calculated using gross total income. For individuals, this represents the percentage of their gross earnings lost to tax.
For example, if a taxpayer earns ₹10 lakh in a year and pays ₹1 lakh in taxes, the effective tax rate is 10%. This gives a clearer picture of the actual tax outflow compared to just looking at slab rates.
Effective Tax Rate vs Marginal Tax Rate
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Marginal tax rate: The rate applied only to the last portion of your income (the highest slab you reach).
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Effective tax rate: The average rate of tax you pay on your total income.
Even if you fall into the highest slab, only part of your income is taxed at that rate. This lowers your overall burden, making the effective tax rate more representative of your true liability.
Why Effective Tax Rate Matters for Taxpayers
Knowing your effective tax rate helps you:
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Assess your actual tax liability.
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Decide whether deductions and exemptions meaningfully reduce your burden.
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Understand the impact of claimed items on your financial position.
Understanding Taxable Income and Total Income
The effective tax rate depends directly on how the income is classified and computed.
Gross Total Income and Total Income Explained
Gross total income includes all sources of income. This includes salary, income from house property, interest income, dividend income, income from savings bank accounts, and other similar earnings. After calculating the gross total income, various tax deductions under the Income Tax Act are applied to arrive at the total income.
Total income is the amount on which the Income Tax Department calculates your tax liability. The effective tax rate is calculated by comparing the total tax paid with your income and is commonly assessed using gross total income.
Deductions and Exemptions That Reduce Taxable Income
Deductions for tax purposes help lower taxable income by reducing the amount of income subject to tax. The deductions may include interest on home loans, health insurance premiums, and even treatment for specific diseases. All these deductions reduce taxable income, thereby reducing the overall and effective tax liability.
Tax Regimes in India and Their Impact on Effective Tax Rate
The tax regime you choose plays a significant role in determining your final tax burden.
Old vs New Regime
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Old regime: Allows multiple deductions and exemptions, reducing taxable income.
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New regime: Offers lower slab rates but disallows most deductions.
Important Update (FY 2025–26):
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New regime slabs (default tax regime):
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Up to ₹4 lakh → 0%
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₹4–8 lakh → 5%
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₹8–12 lakh → 10%
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₹12–16 lakh → 15%
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₹16–20 lakh → 20%
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₹20–24 lakh → 25%
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Above ₹24 lakh → 30%
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Rebate under Section 87A makes income up to ₹12 lakh effectively tax-free for salaried individuals.
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Old regime slabs (unchanged):
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Up to ₹2.5 lakh → 0%
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₹2.5–5 lakh → 5%
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₹5–10 lakh → 20%
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Above ₹10 lakh → 30%
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How to Calculate Effective Tax Rate
Finding the effective tax rate is a simple procedure once you have identified your income details and selected the relevant tax regime.
Step-by-Step Income Tax Calculation
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First, determine your total taxable income by including income from all sources. If you opt for the old tax regime, you can apply eligible deductions and exemptions.
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Next, apply the applicable income tax slabs for the selected tax regime to calculate the basic tax liability.
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Add any applicable surcharge, health cess, and education cess to arrive at the total tax payable.
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Finally, divide the total tax paid by your gross total income and convert it into a percentage to calculate your effective tax rate.
Effective Tax Rate Explained with Examples
Practical examples help understand how the effective tax rate differs from the applicable income tax slab rates in real-life scenarios.
Effective Tax Rate Example for a Salaried Individual (Old Tax Regime)
An individual with a salary has an annual income of Rs 15 Lakh. The individual uses the deductions allowed under the old tax regime and has a taxable income of Rs. 12 Lakh after deductions. Using the income tax slabs, the total liability, including health and education cess, is calculated as Rs. 1,79,400.
The effective tax rate is calculated by dividing the total tax paid by the gross income:
(Rs 1,79,400 ÷ Rs 15,00,000) x 100 = 11.96%
This shows that although the individual falls in the 30% marginal tax slab, only about 12% of their total income is paid as tax.
Effective Tax Rate Example Under the New Tax Regime
The same individual cannot claim deductions under the new tax regime. The tax is calculated on the whole Rs. 15 Lakh of income. Using the income tax slabs, the total liability, including cess, is calculated as Rs 1,56,000.
The effective tax rate is calculated by dividing the total tax paid by the gross income:
(Rs 1,56,000 ÷ Rs 15,00,000) x 100 = 10.4%
Although the old tax regime allows deductions that reduce taxable income, the new tax regime results in a lower effective tax rate for an income of Rs. 15 lakh due to lower slab rates. This highlights why comparing effective tax rates provides a clearer picture of the actual tax burden than looking at slab rates alone.
Old vs New Tax Regime: Effective Tax Rate Comparison
The table below summarises the difference in tax outcomes under both regimes:
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Special Considerations Affecting Effective Tax Rate
Specific income scenarios and taxpayer-specific factors require additional consideration when evaluating the effective tax rate.
Impact of Income Growth and Higher Tax Brackets
As income rises, more of it is taxed at higher marginal tax rates. However, the effective tax rate increases gradually rather than suddenly. This is because only the income that falls into a higher tax bracket is taxed at the higher rate. This ensures there is no abrupt jump in the overall tax burden when moving from one tax slab to the next.
Role of Tax Benefits and Eligible Deductions
Tax benefits such as deductions for prescribed funds, eligible project funds, electoral trust deduction, and rural development conservation help reduce taxable income. Contributions to such schemes can lower total tax liability and, in turn, improve the effective tax rate.
Rebate impact
Under the new regime, income up to ₹12 lakh may attract zero tax due to a rebate, making the effective tax rate 0% for many middle-income earners.
Read Also: New Income Tax Slabs for 2025-26: What Do the New Slabs Mean for You?
To Conclude
An individual’s effective tax rate measures the actual amount of tax paid in relation to total income. Unlike the marginal tax rate, it accounts for deductions and exemptions, providing a more accurate view of the actual tax burden. Understanding how to calculate the effective tax rate helps you manage your income tax liability more effectively and make informed financial decisions.
FAQs
What is the difference between effective and statutory tax rates?
Statutory tax is the tax rate as shown in the income tax slabs, while effective tax reflects the actual tax paid. It takes into account all the deductions, cesses, and rebates.
How are income tax slabs determined in India?
The Central Government of India notifies the income tax slabs each financial year through the Finance Act. These slabs differ under the old and new tax regimes and determine the rate at which income is taxed.
What does the marginal tax rate mean in India?
The marginal tax rate in India is the tax rate that applies only to the portion of income chargeable to tax. This portion is the one that falls into the highest tax slab you reach.
How to calculate the marginal tax rate?
The marginal tax rate is the tax rate that applies to the last rupee of your taxable income. To determine it, identify the income tax slab in which your previous taxable income falls.
How does the income tax rebate work in India?
India’s income tax system provides a rebate to eligible taxpayers whose total income falls within a specified threshold under the applicable tax regime. When this rebate is applied, it can reduce the net tax payable to zero. This happens even though the tax is initially calculated based on the income tax slabs.
What is Marginal Relief?
Marginal Relief is a relief from surcharge, provided in cases where the surcharge payable exceeds the additional income that makes the person liable for surcharge
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