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.
