Tax Credits and Deductions

Tax credits and deductions are two ways to reduce tax liability. Tax credits directly reduce the amount of taxes owed, dollar-for-dollar. If the credit is refundable, people can receive a tax refund even if the benefit exceeds the amount of their tax liability. Nonrefundable credits, on the other hand, benefit only those who owe tax.

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 behaviors or provide targeted relief. For example, the medical expense deduction helps people with very high medical bills. The Earned Income Tax Credit (EITC) encourages work among households with low incomes and improves their financial position. Some business tax credits encourage economic development.

Medical expense deduction
Taxpayers who itemize deductions can claim a deduction for a portion of medical expenses that exceed 7.5 percent of the taxpayer's income. The deduction tends to help people with extraordinary out-of-pocket expenses. Older people are more likely than younger people to claim the deduction.

Earned Income Tax Credit
Created in 1975, the EITC has grown into the federal government's largest needs-tested antipoverty program. It gives workers with low incomes a refundable tax credit. The maximum credit provided is roughly $7,800. This is for workers with three or more kids and income below $60,000 (for a single filer) or $67,000 (married filing jointly). Many states offer their own add-on EITC versions.

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.

However, the current structure of the federal EITC limits its effectiveness in providing financial security and work incentives for childless and older workers. The maximum credit amount and income eligibility limits are substantially lower for childless workers compared to families with children. The maximum credit is $632 for childless workers, and the income limits are $18,600 (for a single filer) or $25,500 (married filing jointly). Also, childless workers must be between the ages of 25 and 64 to qualify for the credit. This means that workers age 65 and over with low incomes are effectively excluded from the program as it is exceptionally rare for individuals at this age to have a qualifying child.

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:

• For retirement savings tax incentives, see Retirement Tax Provisions.
• For tax incentives to expand health coverage, see Expanded Access to Health Care.
• For tax credits to caregivers and incentives for buying private long-term care insurance, see Support for Family Caregivers and Private Long-Term Care Insurance.
• For tax credits to expand subsidized rental housing and ways to improve the Low-Income Housing Tax Credit program, see Subsidized Rental Housing.
• For tax incentives to ensure access to high-speed internet services, High-Speed Internet Services.