What is a Tax Bracket?

Currently, the Internal Revenue Service (IRS) uses tax bracket, a progressive tax system, to gain government revenue. Under this system, U.S. income tax rates are divided into seven segments, ranging from 10% to 37 %.

Noted that tax rates are not the same as tax bracket. The former one refers to the percentage at which income is taxed while the latter one has different tax rates, including 10%, 12%, 22%, etc., which is known as marginal rate.

How does Tax Bracket Work?

Tax bracket is a progressive tax system, which means that people with lower income are subject to lower tax rates while people with higher income are subject to higher rates. Unless taxpayers’ incomes fall into the lowest tax bracket, they should pay the tax at multiple rates as their income rises, rather than the rate of the bracket they fall into. In a word, the more the taxpayers earn, the more they pay.

Different taxpayers or “filers” such as single filers, married joint filers, married filing separate filers, and head of household filers have various tax rates, which leads to 28 effective tax brackets.

Taxpayers should calculate their taxable income first if they try to determine which tax bracket to use. Their taxable incomes equal to their earned and investment income minus adjustments and deductions.

Considering the fact that taxpayers’ incomes are taxed progressively, their tax bracket does not reflect the exact amount of taxation. If taxpayers wish to figure it out clearly, they should use another index- effective tax rate.

Let’s use an example to see how it works.

Suppose there is a single filer who earned $60,000 in 2020. The tax responsibility should be calculated in this way:

  • The first $9,875 is taxed at 10%: $9,875 x 0.10 = $987.5
  • Then the excess over $9,875 ($9,706 to $40,125 or $30,249), is taxed at 12%:

$30,249 x 0.12 = $3,629.88

  • Finally, the excess over $40,125 ($40,126 to $60,000 or $19,874), is taxed at 22%:

$19,874 x 0.22 = $4,372.28

  • The total taxation = $987.5+$3,629.88+$4,372.28=$8,989.66
  • The effective tax rate=$8,989.66/$60,000=14.98%

Pros and Cons of Tax Brackets

  • Pros
  • Tax brackets help alleviate the inequality of income distribution. Higher-income individuals can afford a good living standard while paying more tax and lower-income individuals can be subject to less taxation to make their ends meet.
  • Tax brackets help government gain more revenue.
  • Tax brackets encourage useful behaviors such as charitable contributions since it gives higher-income individuals credits or tax deduction to lower their tax bill.
  • Tax brackets work as an automatic stabilizer on individual’s after-tax income. Under this system, a decrease in income is counteracted by a decrease in tax rate, giving them a more stable income.
  • Cons
  • Tax brackets are not fair for higher-income individuals. There should be no discrimination regarding income status.
  • Tax brackets push higher-income individuals to find ways to exploit tax low loopholes and shelter their earnings, which will in fact depriving the government of revenue.
  •  Tax brackets cause a decrease in personal savings.

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