Tax Bracket

Most income tax systems divide income into bands. Each band, or bracket, has its own rate. Importantly, only the income within each bracket is taxed at that bracket's rate.

For example, imagine a hypothetical system with three brackets: 0% on the first 10,000 of income, 10% on income between 10,000 and 40,000, and 20% on income above 40,000. Someone earning 50,000 pays nothing on the first 10,000, 3,000 on the next 30,000 and 2,000 on the final 10,000, a total of 5,000.

A common misunderstanding is that moving into a higher bracket means all income is taxed at the higher rate. It does not. In the example, earning one more unit above 40,000 only adds tax at 20% on that extra unit. Earning more never leaves you with less after tax from income tax alone.

The rate applied to your last unit of income is your marginal tax rate, 20% here. Your total tax divided by total income is your effective or average tax rate, 10% here. Bracket thresholds and rates differ by country and are often adjusted for inflation.