Question

Please explain the difference between a deduction and a credit.

Which are the refundable credits?

Why do you think we have refundable credits?

Answer 1

A tax credit is basically a one-to-one reduction in the income tax liability. Let's say your income tax liability for the current period is $100 and you have $10 of tax credit available. Hence what tax credit does is reduce your income tax liability of $100 by $10 to $90. Such tax credit can be refundable or non-refundable.

On the other hand, a tax deduction does not reduce your income tax liability, rather, it lowers your taxable income on which income tax liability is computed. Let's say your taxable income is $10,000 and tax rate is 30% and you have a tax deduction available for $1,000. Now what this deduction does is reduce your taxable income of $10,000 by $1,000 to $9,000 and now tax is computed @ 30% of $9,000 which is equal to $2,700.

Refundable tax credit is basically a that tax credit which not only has benefit of reducing your tax liability to 0, but, if any excess tax credit is left after reducing the tax liability to 0, you will receive actual refund of such leftover amount. Changing the 1st example in the 1st paragraph a bit, let's say, instead of $10 of tax credit you have $110 of tax credit available. In such a case your tax liability will not only reduce to 0 but you will also be eligible to receive refund of $10.

Refundable tax credits are much more progressive than non-refundable tax credit in the sense that they provide the added benefit or rather, benefit in full even if the taxpayer does not have tax liability.