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. 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 low incomes. 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 need-tested antipoverty program that provides cash to workers with low incomes. For large families with income below $20,000, the amount of the credit may exceed $6,700. 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 size of the credit for them is much smaller than that for families with children. Income eligibility limits are several times lower as well. On top of that, eligibility is restricted by age to those between the ages of 25 and 64. 

In 2021, under the American Rescue Plan, policymakers repealed the age restrictions and increased the amount of the credit almost threefold for childless workers. These modifications expired at the end of 2021. Once again, workers age 65 and over with low incomes effectively became 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:



Medical expense deduction

The threshold for the medical expense deduction should be kept as low as possible.

Earned income tax credit (EITC)

Congress and the states should extend the EITC to workers with low incomes who have no dependents regardless of age, including those ages 65 and older, provided they are not dependents themselves. Policymakers should also increase the credit for those workers without dependents. Congress should provide funds to the Internal Revenue Service (IRS) for EITC education and counseling programs to encourage eligible taxpayers to obtain the credit. 

The IRS should increase funding for tax assistance programs to help eligible workers with low incomes receive the credit. 

When states experience surpluses that allow them to cut taxes, they should enact or expand EITCs in a fiscally responsible manner. 

Business tax incentives

States and localities should carefully evaluate the effectiveness of the incentives they offer to attract or retain businesses. 

Any incentives offered to businesses should be transparent with respect to costs and beneficiaries.