Income Tax Issues: What is the difference between tax deductions and tax credits?
Tax deductions and tax credits can both reduce an individual’s income tax liability, but they do it in different ways. Tax deductions reduce taxable income; their value thus depends on the taxpayer’s marginal tax rate, which rises with income. Because deductions cannot reduce taxable income below zero, their value is limited to the filer’s tax liability before applying the deduction. In contrast, tax credits directly reduce a person’s tax liability and hence have the same value for all taxpayers with tax liability at least equal to the credit. In addition, some credits are refundable; they are not limited by the taxpayer’s tax liability. As a general rule for policy, tax deductions make most sense for items that represent reductions in ability to pay tax, such as casualty losses. Credits are more appropriate for subsidies provided through the tax system.
- An individual tax filer has the choice of claiming the standard deduction or itemizing deductible expenses for items such as state and local taxes paid, mortgage interest, and charitable contributions. In either case, taxable income is decreased by the amount of the allowed deduction. The deduction reduces tax liability by the amount of the deduction times the filer’s marginal tax rate and is thus worth more to taxpayers in higher tax brackets. For example, a $10,000 deduction reduces taxes $1,500 for people in the 15 percent tax bracket, whereas the same deduction cuts taxes $3,500 for those in the 35 percent tax bracket.
- The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 allows all taxpayers to claim the full value of their itemized deductions in 2011 and 2012. However, if the relevant provision expires in 2013 as currently scheduled, high-income taxpayers will have to reduce their itemized deductions and thus will not benefit fully from their itemizable expenses. The reduction in 2013 will be 3 percent of the amount which adjusted gross income (AGI) exceeds $174,450 ($87,225 for married couples filing separately), up to 80 percent of total itemized deductions.
- The standard deduction and some itemized deductions are disallowed under the alternative minimum tax (AMT). For example, AMT taxpayers may not deduct state and local tax payments or items in the "miscellaneous" deductions category. The AMT reduces but does not eliminate other deductions. Medical expenses in excess of 7.5 percent of AGI, for example, may be deducted under the regular income tax, but the threshold is 10 percent of AGI under the AMT.
- Tax filers may claim some deductions in addition to the standard deduction or itemized deductions. These include deductions for contributions to Individual Retirement Accounts, alimony payments, certain moving expenses, and interest on student loans, among others. The personal exemption ($3,700 each for taxpayers and their dependents in 2011) is also, in effect, a deduction, because it reduces taxable income. The value of all of these deductions depends on the taxpayer’s marginal tax rate and tax liability.
- Tax credits are subtracted not from taxable income but directly from a person’s tax liability; they thus reduce taxes dollar for dollar. As a result, credits have the same value for everyone who can claim their full value.
- Most tax credits are nonrefundable; that is, they cannot reduce a person’s tax liability below zero. As a result, low-income tax filers often cannot get the full benefit of the credits for which they qualify. Some tax credits, however, are fully or partially refundable: if their value exceeds a person’s tax liability, the excess is paid to the filer. The earned income tax credit (EITC) is fully refundable; the child tax credit (CTC) is refundable only to the extent that the filer’s earnings exceed a specified threshold—$3,000 in 2011. These two credits accounted for more than 52 percent of the dollar value of all credits claimed in 2009 (see figure).