The Daily Technical #135: What is an illiquidity discount?

How to answer "Why is the effective and marginal tax rate often different?"

March 18, 2025

Good evening. Welcome to the 135th edition of The Daily Technical.

Now, you’re here for one reason, so let’s dive in.

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OVERVIEW OF YESTERDAY’S QUESTION
Why is the effective and marginal tax rate often different?

Effective and marginal tax rates differ because the effective tax rate calculation uses pre-tax income from the accrual-based income statement.

Since there's a difference between the taxable income on the income statement and taxable income shown on the tax filing, the tax rates will nearly always be different.

Thus, the “Tax Provision” line item on the income statement rarely matches the actual cash taxes paid to the IRS.

Common Mistakes

  1. Mixing up terms like effective and marginal tax rates. Effective tax rate refers to the overall percentage of income paid in taxes, while marginal tax rate is the rate paid on the last dollar earned. Ensure clarity by defining terms at the start.

  2. Not emphasizing the difference between accrual-based income statements and cash-based tax filings. Highlight how accrual accounting records income and expenses when incurred, causing differences from the cash flow perspective.

  3. Misusing the “Tax Provision” line item by assuming it equals cash taxes paid. Explain that tax provisions estimate taxes on an income statement but don't reflect timing differences in tax payments.

TL;DR

  • Effective tax rate uses accrual-based pre-tax income; marginal rate applies to increments.

  • Discrepancies arise between accrual tax income and tax filing income.

  • "Tax Provision" on income statements rarely matches IRS cash taxes.

  • Differences in calculation explain misalignment between rates.

TODAY’S QUESTION
What is an illiquidity discount?

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