Deductions and credits

What Are Deductions and Credits?

Deductions and credits are two distinct mechanisms within the taxation system designed to reduce an individual's or entity's tax burden. While both serve to lower the amount of tax owed, they do so in different ways. A tax deduction reduces an individual's taxable income, thereby lowering the amount of income subject to tax. Conversely, a tax credit directly reduces the amount of tax liability dollar-for-dollar. Understanding the difference between deductions and credits is crucial for effective tax planning.

History and Origin

The concept of reducing tax burdens through deductions and credits has evolved significantly alongside modern tax systems. In the United States, the federal income tax was formally established with the 16th Amendment in 1913. Initially, only a small percentage of wealthy Americans paid income tax. This changed dramatically with World War II, when the need for increased government revenue led to a significant expansion of the tax base. To simplify the process for millions of new taxpayers, Congress introduced the standard deduction in 1944. This allowed taxpayers to deduct a fixed percentage of their income, rather than meticulously tracking itemized deductions for various expenses.¹¹,¹⁰ This innovation aimed to streamline the tax system and ease compliance for the general public.

Later, major legislative reforms like the Tax Cuts and Jobs Act (TCJA) of 2017, formally known as H.R. 1, made substantial changes to both deductions and credits.⁹ The TCJA significantly increased the standard deduction, while also modifying or eliminating various itemized deductions and adjusting family tax credits.⁸,

Key Takeaways

• Deductions reduce a taxpayer's gross income to arrive at their adjusted gross income (AGI) or taxable income, lowering the amount of income subject to tax.
• Credits directly reduce the amount of tax owed, dollar-for-dollar, after the tax liability has been calculated.
• The value of a deduction depends on the taxpayer's marginal tax rate, while a credit provides the same direct savings regardless of tax bracket.
• Some tax credits are "refundable," meaning a taxpayer can receive money back even if their credit exceeds their tax liability, while "non-refundable" credits can only reduce tax owed to zero.
• Utilizing deductions and credits is a legal way for individuals and businesses to lower their overall tax burden.

Interpreting Deductions and Credits

The core difference in interpreting deductions and credits lies in their impact on the final tax liability. A deduction reduces the base upon which taxes are calculated. For example, a $1,000 deduction for someone in the 22% tax bracket saves $220 in taxes ($1,000 * 0.22). The benefit of the deduction scales with the taxpayer's marginal tax rate.

In contrast, a tax credit provides a direct reduction in the tax bill. A $1,000 tax credit reduces the amount of tax owed by exactly $1,000, regardless of the taxpayer's tax bracket. This means that a credit typically offers a more impactful benefit than a deduction of the same amount for most taxpayers, especially those in lower tax brackets. Some credits, known as refundable tax credits, can even result in a tax refund if the credit amount is greater than the tax owed. Others are non-refundable tax credits, meaning they can reduce a tax bill to zero but cannot result in a refund.

Hypothetical Example

Consider an individual, Sarah, with a gross income of $70,000. For simplicity, assume her marginal tax rate is 22%.

Scenario 1: Deduction
Sarah qualifies for a $5,000 tax deduction for student loan interest.
Her taxable income is reduced to:

The tax savings from this deduction would be:

Sarah's tax burden is lowered because less of her income is subject to tax.

Scenario 2: Credit
Instead, imagine Sarah qualifies for a $1,000 tax credit for energy-efficient home improvements.
Her tax liability, before considering the credit, is calculated based on her full taxable income (let's say it's $10,000).
Her final tax liability after the credit would be:

In this case, the $1,000 credit directly reduces her tax bill by $1,000, irrespective of her marginal tax rate.

Practical Applications

Deductions and credits are pervasive in financial planning and daily economic life. Individuals often encounter them when filing their annual tax return. Common deductions include contributions to traditional Individual Retirement Accounts (IRAs), health savings accounts (HSAs), and student loan interest. For those who itemize, deductions might include mortgage interest, state and local taxes (subject to limits), and charitable contributions.

Tax credits frequently support specific policy goals, such as encouraging education, energy efficiency, or family support. The Child Tax Credit, for instance, has been a significant component of family financial support, undergoing expansions, as observed in recent legislative efforts.⁷,⁶,⁵ Such expansions can have a measurable impact on the financial well-being of households. Data from the Federal Reserve, for example, has indicated that the expiration of expanded Child Tax Credits led to increased financial strain for many families, highlighting the real-world economic effects of these provisions.⁴

Limitations and Criticisms

While deductions and credits aim to alleviate tax burdens and incentivize certain behaviors, they also face limitations and criticisms. One common critique is that deductions disproportionately benefit higher-income individuals because the value of a deduction increases with a higher tax bracket. This can exacerbate income inequality by providing greater tax relief to those already earning more.

Another limitation is complexity. The vast array of available deductions and credits, along with their associated rules, phase-outs, and eligibility requirements, can make the tax system incredibly complicated. This complexity can lead to errors, necessitate professional assistance, and create challenges for individuals trying to manage their own finances. Attempts at tax reform, such as the Tax Cuts and Jobs Act, often seek to simplify the system, but invariably introduce new complexities or modify existing ones.³,²

Furthermore, the effectiveness of tax incentives in changing behavior is sometimes debated. For example, while certain tax credits aim to boost economic activity, their actual impact can be smaller than anticipated or generate unintended consequences.¹ The administrative burden on both taxpayers and the taxing authority, such as the IRS, to verify claims and prevent misuse, is also a continuous challenge, sometimes leading to a tax audit.

Deductions and Credits vs. Tax Exemptions

While deductions and credits both reduce a taxpayer's financial obligation, tax exemptions operate differently. A tax exemption typically refers to income or assets that are entirely free from tax. For example, certain types of income, such as interest from municipal bonds, might be exempt from federal, state, or local taxes. In the past, individuals could also claim personal exemptions for themselves, their spouse, and dependents, which directly reduced their taxable income by a set amount for each exemption. However, the Tax Cuts and Jobs Act of 2017 eliminated personal exemptions for many taxpayers, effectively rolling their benefit into a larger standard deduction. Deductions reduce the amount of income on which taxes are calculated, while credits reduce the tax bill directly. Exemptions, on the other hand, identify specific income or entities that are simply not subject to taxation in the first place.

FAQs

Q1: What is the main difference between a tax deduction and a tax credit?

A tax deduction reduces your taxable income, meaning you pay tax on a smaller amount of money. A tax credit, conversely, directly reduces the amount of tax you owe, dollar-for-dollar. For example, a $100 deduction saves you $22 if you are in the 22% tax bracket, while a $100 credit saves you the full $100.

Q2: Is it better to have a deduction or a credit?

Generally, a tax credit is more valuable than a deduction of the same amount because it directly reduces your tax bill. The benefit of a deduction depends on your marginal tax rate, whereas a credit provides a consistent dollar-for-dollar reduction regardless of your income level.

Q3: What is adjusted gross income (AGI) and how do deductions affect it?

Adjusted gross income (AGI) is your gross income minus certain specific deductions, often called "above-the-line" deductions. Many tax benefits, including certain credits and other deductions, are calculated or limited based on your AGI, making it an important figure in your tax return. Deductions reduce your AGI, which can make you eligible for more credits or higher deduction amounts that have AGI limitations.

Q4: Can I claim both the standard deduction and itemized deductions?

No, you must choose one or the other. You can either take the standard deduction, which is a fixed dollar amount determined by the IRS based on your filing status, or you can itemize your itemized deductions, which involves listing out specific eligible expenses like mortgage interest, state and local taxes, and charitable contributions. You should choose the method that results in a lower taxable income.

Q5: What is a refundable vs. non-refundable tax credit?

A refundable tax credit can reduce your tax liability to below zero, meaning you could receive a refund even if you owe no taxes. An example is a portion of the Child Tax Credit. A non-refundable tax credit can reduce your tax liability to zero, but it cannot result in a refund of any excess credit amount. For instance, the Child and Dependent Care Credit is often non-refundable.