Introduction:
Defining Tax Deductions and Tax Credits
In terms of tax planning, taxpayers can use the most powerful of all two instruments at their disposal: tax deductions and tax credits. tax liability, these two mechanisms can help, but their effects on the final tax owed varies. For both individual taxpayers, as well as businesses, understanding the distinctions between tax deductions and tax credits is essential for navigating through savings and tax laws fully.
Tax Deduction: Tax deductions directly reduce the amount of taxable income, thus reducing the total income subject to taxation. Deductions are usually expenses that the tax code permits to be removed from gross income so as to obtain taxable income. A taxpayer’s marginal tax rate affects the impact of a deduction.
Examples of Common Tax Deductions
- Mortgage interest deduction
- State and local taxes (SALT) deduction
- Charitable contributions
- Student loan interest deduction
- Business expenses (for self-employed individuals)
- Medical expenses exceeding a certain percentage of AGI
Impact of Tax Deductions
Since tax deductions reduce taxable income, their benefit depends on the taxpayer’s marginal tax rate. For example, a $10,000 deduction for a taxpayer in the 25% tax bracket results in a tax savings of $2,500. This illustrates that higher-income earners benefit more from deductions than lower-income earners, aligning with the principle of ability to pay in taxation law.
What Are Tax Credits?
A tax credit, on the other hand, directly reduces the amount of tax owed rather than reducing taxable income. Tax credits can be either refundable or non-refundable. A refundable tax credit allows taxpayers to receive a refund if the credit amount exceeds their tax liability, while a non-refundable tax credit only reduces the tax liability to zero but does not provide a refund for any excess amount.
Examples of Common Tax Credits
- Child Tax Credit
- Earned Income Tax Credit (EITC)
- American Opportunity Credit (for education expenses)
- Residential Energy Tax Credits
- Adoption Credit
- Foreign Tax Credit
Impact of Tax Credits
Since tax credits directly reduce tax liability, they provide a greater financial benefit than tax deductions of the same amount. For instance, a $2,000 tax credit reduces taxes by the full $2,000, whereas a $2,000 deduction reduces taxable income, leading to a lower actual tax reduction depending on the taxpayer’s tax rate.
Key Differences Between Tax Deductions and Tax Credits
| Feature | Tax Deduction | Tax Credit |
| Effect on Taxes | Reduces taxable income | Directly reduces tax owed |
| Value Dependency | Depends on taxpayer’s marginal tax rate | Dollar-for-dollar tax reduction |
| Refund-ability | Non-refundable | Some credits are refundable |
| Examples | Mortgage interest, student loan interest, medical expenses | Earned Income Tax Credit (EITC), Child Tax Credit, American Opportunity Tax Credit |
Types of Tax Deductions
Tax deductions are divided into two broad categories as discussed below:
Standard vs. Itemised Deductions: An individual taxpayer may opt to either take a standard deduction, which is a fixed amount the IRS provides each tax year, or itemise all specific expenses, including a portion of mortgage or medical expenses along with state taxes, and sum them together as deductions.
Above-the-Line vs. Below-the-Line Deductions: Above-the-line deductions, which include contributing to retirement plans or donating to health savings accounts, are taken before determining one’s adjusted gross income. On the other hand, below-the-line deductions, such as certain medical costs or interest on mortgages, are taken after the AGI is calculated.
Types of Tax Credits
Tax credits fall into two main categories:
- Refundable Tax Credits: These credits can reduce tax liability to below zero, resulting in a refund to the taxpayer. Examples include the Earned Income Tax Credit (EITC) and the Additional Child Tax Credit.
- Non-Refundable Tax Credits: These credits can only reduce tax liability to zero, meaning any remaining portion of the credit is forfeited. Examples include the Lifetime Learning Credit and the Adoption Tax Credit.
Examples and Impact on Tax Liability
To illustrate the difference, consider the following scenario:
- Tax Deduction Example: Suppose a taxpayer in the 24% tax bracket has a $10,000 deduction. This reduces taxable income by $10,000, saving the taxpayer $2,400 in taxes (24% of $10,000).
- Tax Credit Example: Suppose the same taxpayer qualifies for a $2,400 tax credit. This credit directly reduces tax owed by $2,400, providing a greater benefit than the deduction in this case.
Legal and Policy Considerations
- The principle of taxation law emphasises equity, efficiency, and simplicity. Deductions and credits are designed to encourage economic behaviour (e.g., homeownership, education, energy-efficient investments) and to provide relief to lower-income taxpayers. However, tax policy debates often centre around the fairness of deductions (which tend to benefit higher-income taxpayers more) versus credits (which can be structured to assist lower-income groups more equitably).
Conclusion
While both tax deductions and tax credits serve to lower tax liability, they function in distinct ways. Deductions reduce taxable income, making them more valuable to high-income earners, whereas credits directly offset taxes owed, benefiting taxpayers across all income levels, particularly low- and middle-income individuals.
