The tax code has two different mechanisms to reduce the amount of tax due from a taxpayer. They are the tax credit and the tax deduction. They work a little differently, but is one better than the other?
The 2017 tax cut law removed a lot of tax deductions, replacing them with tax credits. Some people thought that the credits were worth less than the previous deductions. For some people, that was true; for others, it was not.
We must begin our discussion of the differences between tax credits and tax deductions by looking at another feature of the United States tax code. That feature is the concept of tax brackets. Only when we understand tax brackets, can we understand the different impact of credits and deductions.
Tax Brackets
For 2025, tax brackets for a married couple, filing jointly, are shown below. There are different tables for single taxpayers, head of household taxpayers, and other taxpayer filing statuses. For our purposes in discussing credits and deductions, we don’t need to consider all of these options, so the married filing jointly table is sufficient.
In computing taxes, the first step is to figure out the total amount of taxable income, then use the rates below to determine the amount of tax that is due.
| Pay | of the amount over | and less than |
| 10% | $0 | $23,850 |
| 12% | 23,850 | 96,950 |
| 22% | 96,950 | 206,700 |
| 24% | 206,700 | 394,600 |
| 32% | 394,600 | 501,050 |
| 35% | 501,050 | 751,600 |
| 37% | 751,600 |
We will run through a few examples to illustrate how this works.
Example 1 : $50,000 family income
Assume a couple with $50,000 of taxable income. That puts the couple in the 12% tax bracket, since their income is between $23,850 and $96,950. The 12% tax rate does not apply to all $50,000 of income.
- The couple will pay 10% tax on the first $23,850 (a tax of $2,385).
- That leaves $26,150 of the $50,000 total to be taxed at the 12% rate (a tax of $3,138)
The total federal income tax for the couple is $5,523.
Example 2 : $125,000 family income
Now, let’s consider a couple with $125,000 in total taxable income. This couple is in the 22% tax bracket. Again, not all of the income is taxed at 22%. Some is taxed at 10%, some at 12%, and some at 22%.
- The couple will pay 10% tax on the first $23,850 (a tax of $2,385)
- The couple will pay 12% tax on the next $73,000 of their income (a tax of $8,772)
- Finally, the couple will pay 22% tax on the remaining $28,050 (a tax of $6,171)
The total income tax for the couple with $125,000 of taxable income is $17,328.
Tax Deduction Example
Tax deductions work by reducing taxable income. Let’s look at how tax deductions for the two example couples above. For tax year 2017, parents could claim a deduction of $4,050 for each child. Let’s assume both couples have two children, for total deductions of $8,100. Now, we need to adjust the taxable income for each of the couples.
The first couple now has a taxable income of $41,900 (the original $50,000 minus the $8,100 deduction). If we recompute the tax, they still pay
- 10% tax on the first $23,850 (a tax of $2,385)
- 12% on the remaining $18,050 of income (a tax of $2,166)
With the $8,100 in deductions, the total tax is now $4,551. This results in a tax savings of $972 for the lower earning couple.
The second couple now has a taxable income of $116,900. If we recompute the tax they still pay
- 10% tax on the first $23,850 (a tax of $2,385)
- 12% tax on the next $73,000 of their income (a tax of $8,772)
- 22% tax on the remaining $19,950 (a tax of $4,389)
The second couple’s total tax with the deductions is $15,546. This represents a tax savings of $1,782. The same tax deduction has a much larger tax benefit for this couple because they are in a higher tax bracket, so the deduction is removing more highly taxed income.
Tax Credit Example
A tax credit is applied after the income tax is computed. If we replace the $4,050 dependent deduction with a $500 tax credit (this was done in the 2017 tax law), let’s see the impact on our two hypothetical families.
The lower income family originally had a total tax of $5,523. If the two dependents now earn a $500 tax credit instead of a $4,050 tax deduction, the total tax for the family drops to $4,523. The lower income family is better off from a tax perspective by $28 with the credit.
The upper income family originally had a total tax of $17,328. Apply the two dependent tax credits, and this family’s tax bill drops to $16,328. The higher income family pays $782 more in taxes with the tax credit than with the tax deduction.
Tax Credits Preferable
We conclude that taxing policy should move toward preferring tax credits over tax deductions. Credits provide identical tax benefit, regardless of the taxpayer’s income level. On the contrary, tax deductions magnify benefits for higher income earners. If we had a single tax rate, instead of a tiered system of tax brackets, credits and deductions would have identical impacts across income levels.
As an example, we would reform the charitable contributions deduction. Instead of offering a straight deduction, we would concert that to a tax credit equal to 10% (the lowest marginal tax rate) of the contribution amount.
We would prefer to see a single tax rate instead of a tiered bracket approach. Absent that, we do believe that the tax benefit of any given action should be the same, regardless of the taxpayer’s income level.