Question

Explain how tax credits differ substantially from tax deduction. Explain which one provides the most tax benefit to taxpayers and why.

Answer 1

Tax credit is the amount of money the taxpayers subtracts from the total taxes that they owe to the government, "dollar to dollar" amount. But Tax deductions reduce the amount of "Taxable income". This means tax deductions also reduce tax liability but only according to the individual's tax slab. Let's assume a person's yearly income is $30,000 , after applying tax deductions of $ 9000, His taxable income is $ 21,000. Let's assume he falls under 30% tax bracket (imaginary) . So total taxes payable by him is $ 21,000 * 0.30 = $ 6300.

Instead if it was tax credit of $ 9000 , then tax payable by him without any tax credit would be

$(30,000 * 0.30)= $9000

After tax credit total tax payable by him would be ( assuming tax credit of $ 9000 instead of tax deduction of $ 9000 as in previous case )

$ 9000 ( tax payable without tax credit) - $ 9000 ( tax credit) = $ 0

So, we see tax credit is more helpful for taxpayers as it reduces the total tax payable amount dollar to dollar, but in tax deduction it reduces individual's tax liability according to his marginal tax rate.