Tax Credits and Deductions

Background

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 the tax and, if refundable, may benefit even those who do not.

In contrast, tax deductions (also called exemptions or exclusions) reduce the amount of income that is subject to tax. A dollar of a deduction reduces taxes by only a fraction of a dollar, as determined by the taxpayer’s applicable tax rate. 

Some of these tax preferences are intended to encourage certain types of activity or 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, and some tax credits for businesses seeking 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 2018, people can deduct any medical expenses in excess of 7.5 percent of income. Without Congressional action, this threshold will rise to 10 percent for tax year 2019.

Earned Income Tax Credit

The EITC, created in 1975, 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. In contrast to some means-tested public benefit programs, receipt of the EITC generally brings no stigma. As a result, the program enjoys a high participation rate.

The current structure of the federal EITC limits its effectiveness at providing financial security and work incentives, particularly for workers with no dependents and for older workers.  The maximum size of the credit for childless workers is much lower—less than $500. Recipients without a qualifying child must be between the ages of 25 and 64 to be eligible, which further limits the EITC’s scope.

Business tax incentives

Some states and localities offer credits and deductions to businesses as a way 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 (see also, Chapter 4, Savings and Retirement Security - Retirement Tax Provisions for more information on retirement savings tax incentives; Chapter 7, Health - Expanding Health Care Coverage for more information on tax incentives to expand health coverage; and Chapter 8, Long-Term Services and Supports - Supporting Family Caregivers for more information tax credits to caregivers and incentives for buying private long-term care insurance).

TAX CREDITS AND DEDUCTIONS: Policy

Medical expense deduction

In this policy: FederalState

Every effort should be made to keep the threshold for the medical expense deduction as low as possible.

Earned income tax credit (EITC)

In this policy: FederalState

Congress and the states should extend the EITC to workers with low incomes regardless of age who have no dependents, provided they are not dependents themselves.

Congress should provide the Internal Revenue Service (IRS) with the revenue necessary to fund education and counseling programs that would encourage eligible taxpayers to obtain the credit. The IRS should increase funding for tax-assistance programs to help workers with low incomes who are eligible to receive the credit.

When states are experiencing surpluses that allow them to cut taxes, they should enact or expand EITCs so that workers with low and moderate incomes and their families can also share in the tax benefits of prosperity.

State and local incentives for businesses

In this policy: LocalState

States and localities should carefully evaluate the incentives they offer to attract or retain business since such subsidies must be offset by higher tax burdens on consumers, other taxpayers, and public institutions. Any incentives offered to business should be transparent with respect to costs and beneficiaries.