From the course: Accounting Foundations

Tax deductions and credits

From the course: Accounting Foundations

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Tax deductions and credits

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- Now, what's the impact of a tax deduction in our simple tax system? Well, let's say you make $100, remember, the first $50 is never taxed, the second $50 would be taxed at the 20% rate. So you'll pay $10 in tax. Now, let's say that of that $100 of income, you decide to spend $10 in a way that the government favors. Perhaps you spend that $10 as a charitable contribution, or you spend that $10 paying mortgage interest on your home. So the government says, "Yeah, we want to encourage that behavior. That's a good way to spend $10." To encourage these behaviors, the government will give you a tax deduction for the $10 that you spent in this favorable way. So how does this $10 deduction enter into the payment of your taxes? Well, now we have to recompute your taxable income. You made $100, but $10 you spent in a very special way, which is tax deductible. So your taxable income is only $90. The first $50 is still tax free, and now the second $40 is taxed at the 20% rate. So you'll pay tax of $8. The $10 tax deduction reduces your income tax from $10 to $8. Again, what are tax deductions? Their expenditures by individuals that the government favors. Examples under the US tax system are charitable contributions, investing in your IRA or your 401k plan, and paying interest on your home mortgage. There are also business tax deductions. If I have a business and I make $100, but then I use $10 to pay wages to my employees or pay electricity on my building, I don't have to pay income tax on that $10 business tax deduction. Any legitimate business expense is a tax deduction. Now, let's say that you spent $10 of your income in a very favored way, according to the government. Maybe you spent the $10 increasing the energy efficiency of your home by putting solar panels on your roof. You did something the government really wants to encourage. In this case, the government will give you a tax credit. So how is the tax credit differ from a tax deduction? Again, you compute your tax of $10 on your $100 in income, but now the government says you spent $10 of your income, so well, you spent it just the same as the government would have. So what the government says is that you can reduce that $10 directly from your taxes. You owe us $10 in taxes. Just subtract that $10 tax credit directly, so that your tax obligation is zero. You owed $10, but the tax credit of $10 means you now owe nothing. The $10 tax deduction reduces my taxes by $2. The $10 tax credit reduces my taxes by $10. So if somebody gives you your choice of calling something a tax deduction or a tax credit, what should you choose? Take the tax credit. Now, of course, you don't get to make this choice. Governments consider which activities they want to encourage and then decide to grant tax deductions for money spent on those things. And governments consider activities they really want to encourage and grant tax credits for money spent on those items.

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