In my understanding tax credits are where the government basically says: "hey, you no longer have to pay federal tax on the things that you buy that pertain to "x", or you have to buy them with tax but at the end of the year the government refunds your tax to you. Is this an accurate description or is there more to tax credits than just that?
A tax credit differs from a tax tax deduction in only one regard - deductions apply before the tax rate, credits afterwards.
From my time at PricewaterhouseCoopers, I can tell you the tax you owe is always calculated as follows:
Tax = ((Income - Deductions) * Rate) - Credits.
If you think of it in this way, the math and the purpose become obvious.
Both tax credits and deductions lower the amount of tax you are obligated to pay. Each reduces the "income" - deductions just apply before the rate, credits after. Put another way, if your rate was 100%, Deductions would be exactly equivalent to a credit. Or, if your rate is 25%, a Deduction would have to be 4 times greater than a credit to have the same effect.
In some instances, tax credits can result in you getting back more money than you spend. Famously, 47% of American taxpayers paid no federal tax. Indeed, with the Earned Income Tax Credit, many families will get back more than they paid causing them, as Planet Money says "to love Tax Day". Along with WIC, it is a major way to actually dole out "welfare."
Why Credits and Deductions at all?
The real question then is not, "Why a deduction vs. a credit," but rather, why does the government allow any deductions or credits whatsoever? The answer is, there are certain activities that the government wants to foster, so they are literally lowering the price of doing it.
Economics 101: If you want more of a thing to consumed, you lower its price.
Some of the most common things the government wants you to do?:
- Give to Charity (Charitable Deductions)
- Buy a House (Mortgage Interest Deductions)
- Stay Healthy / Get Healthcare (Health Care costs are deductible for employers)
- Support your Children (Earned Income Tax Credit)
Financially, there is no difference between a tax deduction/credit and a subsidy - except when and how you get your money. A subsidy would be paid to you directly, or since you have to file your taxes every year anyway, you can just settle up then.
Imagine, for example, that you are a low income worker with kids. You are eligible for the Earned Income Tax Credit - probably the most successful "welfare" program in the United States.
Over the course of the year, let's say you have about $2000 in taxes withheld. The government wants you to have children (avoid being like Japan, and have someone to pay your Social Security later ya know!), and so they want to make it cheaper for you to have kids.
They have a few options: - Give away a certain amount of kid-related items for free - Reduce the price of the kid items - Reduce the sales tax on kid items (just another way of reducing the price) - Give you a certain amount of money - Just reduce the amount of money you need pay them for everything else.
It's a spectrum of ease for the government. If you owe your friend $15, and your friend owes you $20, don't you normally just pay the $5 difference? That's what the government is doing. Its a bit silly to do all the extra accounting and infrastructure and planning, when the easiest thing to do is settle up at tax time.
That is what a tax credit and/or a deduction does. If the government is going to transfer wealth, this is an easy way to do it.
In a nutshell:
A tax credit is a straight discount your get off your taxes. As an example, let's say you made $100 this year, have to pay 25% in taxes and have a $10 tax credit. You would normally owe in taxes $25 (the 25% from your earned $100), but your tax credit gets you $10 off the $25, so you end up paying an effective $15 in taxes.
A deduction is a discount you get on your taxable income. As an example, let's say you made $100 this year, have to pay 25% in taxes and have a $20 deduction. You apply the $20 deduction to your $100 income, which results in $80 and then pay your 25% tax on that, so you end up paying an effective $20 in taxes (25% of $80).