Tax credits and deductions are two ways to reduce tax liability. Tax credits directly reduce the amount of taxes owed, dollar-for-dollar. They benefit all those who owe tax. If the credit is refundable, people can receive a tax refund even if the benefit exceeds the amount of their tax liability.
In contrast, tax deductions reduce the amount of income that is subject to tax. They are also called exemptions or exclusions. A dollar of a deduction reduces taxes by only a fraction of a dollar, determined by the taxpayer’s applicable tax rate.
Some of these tax preferences are intended to encourage certain types of activity. Or, they may provide relief for people in certain situations. For example, the medical expense deduction helps people with very high medical bills. The Earned Income Tax Credit (EITC) primarily aims to improve the financial position of working families with children. Some tax credits are offered to businesses to encourage economic development in a local jurisdiction.
Medical expense deduction
Some taxpayers with high medical expenses can claim a deduction for a portion of those expenses. Older people are more likely than younger people to claim the deduction. For tax year 2020, people can deduct any medical expenses in excess of 7.5 percent of income. Without periodic congressional extensions, this threshold will rise to 10 percent.
Earned Income Tax Credit
Created in 1975, the EITC is a major federal program to assist the working poor. This refundable tax credit has grown into the federal government’s largest antipoverty program. Many states offer their own versions of the federal credit.
The EITC enjoys widespread support. The credit boosts the financial security of working families and increases work incentives. Receipt of the EITC does not carry a stigma in contrast to some means-tested public-benefit programs. As a result, the credit enjoys a high participation rate.
However, the current structure of the federal EITC limits its effectiveness at providing financial security and work incentives. That is particularly true for workers with no dependents and older workers. The maximum size of the credit for childless workers is much lower. In tax year 2020, the maximum amount was $538 for a worker with no dependents compared with $6,660 with three or more qualifying children. Recipients without a qualifying child must be between the ages of 25 and 64 to be eligible. This further limits the EITC’s scope.
Business tax incentives
Some states and localities offer credits and deductions to businesses to encourage job creation and capital investment. Often governments compete to lure businesses, undermining each other’s efforts. The effectiveness of these incentives is unclear.
For further information on other credits and deductions, see the following Policy Book sections: