If you’re one of those people who hand your taxes to someone else to prepare, the talk about “tax credit” vs “tax deduction” may seem like just more accountant mumbo-jumbo. But as a citizen, you need to know the difference, so you can decide if a particular deduction or credit is worth the cost. And the difference is huge.
A tax deduction is a deduction you get to take against your income. Thus, it lowers your taxable income (the amount of your income that is subject to tax), and therefore it lowers your taxes. The value of the deduction is a simple calculation – the amount of the deduction times your tax rate.
Let’s say you give $1,000 to a charity, thus getting a tax deduction. You can subtract that charitable donation from your total income, lowering the amount you have to pay taxes on by $1,000. If you are taxed at a 25% rate, that lowers your taxes by $250. So in the end, that $1,000 donation only costs you $750. (We’re oversimplifying here, but you get the idea.)
A tax credit, on the other hand, is taken off of your taxes themselves, usually on a 1-for-1 basis. It doesn’t matter what your tax rate is; the amount of the tax credit comes right off your tax bill.
So, let’s say you give that same $1,000 to a charter school, because your state has put in place a tax credit for giving to charter schools. When you file your taxes, you calculate your overall tax bill – and then take that $1,000 right off your taxes. It doesn’t matter if your tax rate is 25%, or 35%, or 10%; you get to take the entire $1,000 off your taxes.
In other words, while that $1,000 charitable donation only cost you $750, that $1,000 gift to that charter school cost you – wait for it – nothing. If you gave $20,000, you’d be able to take the entire amount off your taxes. Whatever you give that qualifies for a tax credit costs you absolutely nothing.
BUT — it does cost something to the rest of us. Because that is $1,000 less that will be coming into the state’s budget … and that means the rest of us have to pick up the slack. If enough people give enough money to things that qualify for tax credits, our state’s budget can be seriously harmed. And that means less money for things like public schools.
Charitable giving also takes some money out of the state’s coffers. But, because the savings is only a percentage of the amount given, the person giving has some skin in the game (as the saying goes). They have to give up $750 to see that $250 in savings.
But the person using the tax credit has NO skin in the game. They are free to take money from the rest of us, at no cost to themselves.
So now you know. And when you hear someone propose a tax credit for something (and Kentucky has a bunch of them), look to see who is set to profit.