- [Instructor] What is the impact
of a tax deduction in our simple tax system?
Let's say you make $100, remember,
the first $50 is never taxed.
The second $50 would be taxed at the 50% rate,
so you'll pay $25 in tax.
Now, let's say that, of that $100 in income,
you decide to spend $10 in a way that the government favors.
Perhaps you spend $10 as a charitable contribution,
or you spend that $10 paying mortgage interest on your home.
So the government says, yeah, we want to encourage
that behavior, that's a good way to spend $10.
To encourage those behaviors,
the government will give you a tax deduction
for the $10 that you spent in this favorable way.
So how does this $10 deduction enter
into the payment of your taxes?
Well, now you have to recompute your taxable income.
You made $100, but $10 you spent in a special way,
which is tax deductible, so your taxable income is only $90.
The first $50 is still tax-free,
and now the second $40 is taxed at the 50% rate,
so you'll pay tax of $20.
The $10 tax deduction reduces your income tax
from $25 down to $20.
Again, what are tax deductions?
They are expenditures by individuals
that the government favors, examples
under the US tax system are charitable contributions,
investing in your IRA or 401(k) retirement plan,
and paying interest on your home mortgage.
There are also business tax deductions.
If I have a business and I make $100,
but then I use $10 to pay wages to my employees,
or pay electricity on my building,
I don't have to pay income tax
on that $10 business tax deduction.
Any legitimate business expense is a tax deduction.
Now, let's say that you spend $10 of your income
in a very favored way, according to the government.
Maybe you spent the $10 increasing the energy efficiency
of your home by putting solar panels on the roof.
You did something that the government
really wants to encourage, in this case,
the government will give you a tax credit.
So how is this different from a tax deduction?
Again, you compute your tax of $25 on your $100 in income.
But now, the government says, you spent the $10
of your income so well, you spent it just the same
as we, the government, would have spent it.
So what the government says is, you can reduce
that $10 directly from your taxes.
You owe us $25 in taxes, just subtract that $10 tax credit
directly, so you only have to pay $15 in taxes.
The $10 tax deduction reduces my taxes by $5.
The $10 tax credit reduces my taxes by $10.
So if somebody gives you your choice
of calling something a tax deduction or a tax credit,
what should you choose?
Take the tax credit.
Well now, of course, you don't get to make this choice.
Governments consider which activities they want
to encourage, and then decide to grant tax deductions
for money spent on those things.
And if a government really wants to encourage an activity,
then they grant tax credits for money spent on those items.