George W. Bush and Al Gore are offering both tax credits and tax deductions. What’s the difference, and how do they work?
(Explainer does not do her own taxes and presents the following hypothetical cases for purposes of explanation only.)
Tax credits directly lower your tax bill. Broadly speaking, if you have $10,000 in taxable income, you’re in the 15 percent federal tax bracket and owe $1,500 in taxes. For every child you have, you’re entitled to a $500 tax credit. Let’s say you have one kid: That $1,500 tax bill would be lowered to $1,000. Tax credits come in two varieties, refundable and nonrefundable. A refundable tax credit allows you take the entire amount of the credit even if it pushes your taxes to less than zero. For example, if you owe $1,000 in taxes but are eligible for a $2,000 tax credit, you can take the whole amount, and the Internal Revenue Service will send you a check for $1,000. The best-known refundable credit is the Earned Income Tax Credit, which is designed to eliminate taxes for the working poor. A nonrefundable tax credit, such as the $500 for each child, allows you only to reduce your taxes to zero.
Tax deductions allow you to reduce your taxable income. Let’s say you make $10,000 and are eligible for a $500 tax deduction (for mortgage interest or charitable contributions, to pick two common deductions). Such a deduction would reduce your taxable income to $9,500, which is in the 15 percent tax bracket. You’d owe $1,425 in taxes.
Tax incentives are any provision designed to reward or promote through tax credits or deductions behavior that lawmakers like. The government believes that home ownership is good, thus the mortgage interest deduction. There are thousands of incentives for business in the tax code, from making fuel out of ethanol to hiring welfare recipients.
The marginal tax rate is the percentage of taxes you pay on a portion of your income as you move into higher tax brackets. There are four tax rates plus a surtax, making five tax brackets. If you’re a married couple filing jointly, your taxable income up to $40,100 is taxed at 15 percent. If you get a raise to $40,101, that next dollar and anything else up to $96,900 is taxed at 28 percent. Keep getting raises, and your additional income can pass through the 31 percent, 36 percent, and 39.6 percent brackets. If the two of you have $100,000 in taxable income, parts of your income are taxed at the 15, 28, and 31 percent brackets. Your effective tax rate is the average of all the marginal tax rates you pay on each portion of your income, in this case 22.8 percent.
Next question (as long as it’s not about taxes)?
Explainer thanks Pete Sepp of the National Taxpayers Union.
