Four families, one tax change, and how a deduction differs from a credit

Two politicians stand on two stages in the same town, and both promise "a thousand-dollar tax break for working families." The crowds cheer at both. Reporters write down both numbers. And one of those promises may be worth eight times as much to the family at the back of the hall as the other, because the word "break" hides the one thing that matters: how the break is built.

Folks, this is the most useful five minutes of tax education I know, and almost nobody gets it. A deduction and a credit both lower your tax. They do it in completely different ways, and the difference decides who wins from a tax change. Once you see it, you will never again hear a politician say "a thousand dollars" without asking the next question.

Here is the rule in one breath. A deduction comes off your income before the rate is applied, so it is worth the deduction times your tax rate. A credit comes off your tax after the rate is applied, so it is worth the full amount, up to the tax you owe, or beyond that if the credit is refundable.

Now let me prove it with four households. Every one of these is a hypothetical. The names are invented, the incomes are invented, and the rates are made up, though they resemble the shape of the real schedule: 10, 12, 22 and 24 percent. I am using rates only and ignoring the dollar thresholds, because the point is the principle. Use the IRS forms and instructions for your own return.

The test: one thousand dollars, two designs

The change under test is a $1,000 tax break. Congress can deliver it two ways.

• Design A, a deduction. Taxable income falls by $1,000.
• Design B, a credit. Tax owed falls by $1,000.

Same headline number. Different results. Watch.

Household one: the single worker

Dana is single, works at a distribution center, and her tax situation puts her top dollars in the 12 percent bracket. Before the change, her federal income tax is $2,600.

Under Design A, a $1,000 deduction cuts her taxable income by $1,000. The tax saved is 12 percent of $1,000, which is $120. Her tax falls from $2,600 to $2,480.

Under Design B, a $1,000 credit comes straight off the bill. Her tax falls from $2,600 to $1,600.

The credit is worth $1,000. The deduction is worth $120. For Dana, the credit is 8.3 times as valuable ($1,000 divided by $120). If a candidate offers Dana "a thousand dollars," the form it takes is the difference between a night out and a month of groceries.

Household two: the married couple with two children

The Reyes family is a married couple with two children. Their top dollars are taxed at 12 percent, and their income tax before the change is $1,800. Suppose the proposal is $1,000 per child, so the total break is $2,000.

Under Design A, a $1,000 per-child deduction removes $2,000 from taxable income. The saving is 12 percent of $2,000, or $240. Their tax falls from $1,800 to $1,560.

Under Design B, a $1,000 per-child credit is worth $2,000 against a tax bill of only $1,800. Here the details of the credit decide everything.

• If the credit is nonrefundable, it can reduce the tax only to zero. The family saves $1,800 and loses the other $200. Their tax falls to $0.
• If the credit is refundable, the leftover $200 is paid to the family as a refund. They are $2,000 better off.

This is not a technicality. It is the entire fight over who benefits from family tax relief. A nonrefundable credit helps only those with enough tax to absorb it. A refundable credit reaches families whose income tax is small or zero, though they still pay payroll taxes on every paycheck. The real-world Child Tax Credit has had both refundable and nonrefundable portions, and the rules have changed over the years, so look at the current form instructions for your year.

There is some history worth knowing. The Taxpayer Relief Act of 1997, signed by President Clinton after a Republican Congress wrote it, created the first federal child credit, $500 per child. The Tax Cuts and Jobs Act, signed in December 2017, raised the child credit from $1,000 to $2,000 per child, and in the same law the personal exemption was set to zero and the standard deduction was roughly doubled. In other words, the Republican answer to family relief has generally been a credit, partly because a credit helps a family at every income level the same amount, and partly because a deduction is worth more to families with higher incomes. Anyone who says Republicans write tax relief only for the rich should look at which design we actually picked. I make that broader case in five changes in the 2017 tax law that reached the kitchen table.

Household three: the retiree

Walt is a retiree living on a pension and some savings. His taxable income is modest, so his top dollars are taxed at only 10 percent, and his income tax before the change is $400.

Under Design A, the $1,000 deduction saves 10 percent of $1,000, which is $100. His tax falls from $400 to $300.

Under Design B, a $1,000 nonrefundable credit can wipe out only the $400 he owes. He saves $400 and the other $600 of the credit evaporates. If the credit were refundable, he would get the $600 in cash and save the full $1,000.

Walt's lesson is that a credit is a powerful tool, yet its power is capped by the tax bill if it is nonrefundable. For a retiree on a small income, the difference between a nonrefundable and a refundable credit is $600. For lawmakers, that is where the argument lies: should a tax credit ever pay people more than they owe in tax? Some conservatives say no, because then it is a spending program in tax clothing. Others point out that these families pay payroll tax, sales tax and property tax, so the credit simply gives some of it back. Both positions have a serious principle behind them, and anybody who tells you there is only one honest view is selling something. The Earned Income Tax Credit, enacted in 1975 and a bipartisan favorite since, is refundable and tied to work, which is a large part of why many Republicans have supported it.

Household four: the shop owner

Lou owns a hardware store and has a good year. His top dollars land in the 24 percent bracket, and his income tax before the change is $24,000.

Under Design A, the $1,000 deduction saves 24 percent of $1,000, which is $240. His tax falls from $24,000 to $23,760.

Under Design B, the $1,000 credit saves $1,000. His tax falls to $23,000.

Notice something. Lou is the person a deduction helps most, and he still gets four times as much from the credit ($1,000 divided by $240 is about 4.2). A credit beats a deduction of the same size for every one of our four households. The deduction's best case is the highest bracket, and even there it loses.

So why would anyone choose a deduction? Because deductions come in different sizes. If Congress gives Lou a $5,000 deduction instead of $1,000, the saving is 24 percent of $5,000, which is $1,200. That is more than the $1,000 credit. The two designs are not the same size at the same label, and the comparison only makes sense when the amounts are equal. Which brings us to the table.

The side-by-side table

Here are all four households together, for the same $1,000 break (a single $1,000 break for each, so the comparison is clean, rather than the per-child version above).

Now flip the question. How large would a deduction have to be to equal a $1,000 credit? Divide $1,000 by the tax rate.

• At 10 percent: $1,000 divided by 0.10 is a $10,000 deduction.
• At 12 percent: $1,000 divided by 0.12 is an $8,333.33 deduction.
• At 24 percent: $1,000 divided by 0.24 is a $4,166.67 deduction.

A deduction has to be much larger to match a credit, and the lower your bracket the larger it has to be. That is the arithmetic of who gets helped. A deduction gives its largest dollars to the taxpayer with the highest rate. A credit gives the same dollars to everybody who can use it.

Two more wrinkles that change the answer

A deduction's value moves with the rate. Because a deduction is worth its size times your rate, anything that changes the rate changes the deduction's worth. Suppose Lou's top rate falls from 24 percent to 22 percent in some hypothetical rate cut. His $5,000 deduction, which saved $1,200, now saves 22 percent of $5,000, or $1,100. He got a rate cut and lost $100 on the deduction at the same time. A credit has no such feature: a $1,000 credit is $1,000 under any rate schedule. That is part of why tax reformers who want lower rates and fewer loopholes, as in the 1986 reform covered in the 1986 tax reform that lowered rates by closing loopholes, find that cutting deductions and cutting rates travel together.

A deduction can be worth nothing at all. Most households take the standard deduction, a flat amount that every filer gets without listing expenses. A new itemized deduction helps only if your itemized total climbs above the standard deduction. Take a hypothetical couple whose standard deduction is $24,000 and whose itemized expenses total $21,500. They take the standard deduction, and a new $1,000 itemized deduction brings their total to $22,500, which is still below $24,000. It saves them exactly $0. If their itemized total had been $23,500, the new deduction would lift it to $24,500, only $500 above the standard amount, and at 12 percent they would save $60. A $1,000 credit, by contrast, helps them no matter how they file. When you hear that Congress is creating a new deduction, ask what share of households itemize, because a deduction that most families cannot use is a smaller promise than it sounds.

The strongest argument for deductions

Here is the best case on the other side, and it comes from a serious place.

A deduction respects the way income is actually earned. When you spend money on something the tax code wants to encourage, such as a mortgage, a charity gift or a business expense, you are not taxed on income that you never really had available to spend. For a business owner, in particular, a deduction for a legitimate cost is not a favor at all. It is the correct measurement of profit. And a deduction costs the Treasury less per dollar than a credit of the same face value, so it is a cheaper way to encourage behavior.

I agree with the business half of that. A shop owner who deducts the cost of inventory is not receiving a subsidy. He is being taxed on profit rather than on revenue, which is what a sensible tax system does. The line between "measuring income correctly" and "encouraging a behavior" is where the argument gets slippery. A deduction for the cost of earning income is accounting. A deduction for something the government wants more of is policy, and policy through the tax code has a bias: it gives more to those with higher bills and higher rates. Nothing wicked about it, but it is worth knowing.

The honest answer is that neither design is always right. For a cost of doing business, a deduction is the correct measure. For a flat benefit meant to help every family by the same amount, a credit does the job. And for a break aimed at people with little or no tax liability, only a refundable credit reaches them at all.

Questions to ask when a politician offers a tax break

You can carry these four into any town hall.

1. Is it a deduction or a credit? If a deduction, ask what rate it saves at and whom that favors.
2. If a credit, is it refundable? If not, the families with the smallest tax bills get the least.
3. Does it phase out? Many deductions and credits shrink as income rises. A break that disappears at a certain income is a different animal from one that does not.
4. How is it adjusted over time? If dollar amounts are not indexed to inflation, the break shrinks each year without a vote. The same silent erosion drives the argument in reagan's 1981 tax cut and the quiet end of bracket creep.

The IRS publishes the actual rules for every deduction and credit in its form instructions and publications, such as Publication 17, Your Federal Income Tax. Read the description of any credit you claim, because the refundability rules are printed there. And to see how these pieces fit onto a real return, Walking through Form 1040 from the first line to the refund follows the lines in order, while seven tax myths that scare working families and cost them money covers the other mix-ups that cost people money.

The bottom line

• A deduction is worth the amount times your tax rate. A $1,000 deduction saves $120 at 12 percent and $240 at 24 percent. A $1,000 credit saves $1,000.
• When someone promises you a number of dollars in tax relief, ask which kind it is. The answer can change the value by a factor of eight.
• Check whether a credit is refundable. A nonrefundable credit cannot give back more than you owe, and the families with the smallest tax bills lose the most.
• Costs of earning income are rightly deducted. Rewards for behavior the government likes are better judged by who they favor.
• Before you vote on any tax change, do the arithmetic on a household like yours, with the rates and the form instructions in hand.