- 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 pay $25 in tax.
Now, let's say of that $100 of income,
you decide to spend $10 in a way that the government favors.
perhaps you spend that $10as a charitable contribution
Perhaps you spend that $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,
we want to encourage that behavior,
"that's a good way to spend $10."
To encourage these behaviors,
the government will give you a tax deduction
for the $10 that you spent in this favorable way.
that you spent in this favorable way.
So how does this $10 deduction
enter into the payment of your taxes?
Well now you have torecompute your taxable income.
Well, now you have to re-compute your taxable income.
You made $100 but $10 youspent in a special way
You made $100, but $10 you spent in a special way
which is tax deductible.
which is tax deductible,
So your taxable income is only $90.
so your taxable income is only $90.
The first $50 is still tax free
The first $50 is still tax free,
and now the second $40is taxed at the 50% rate
and now the second $40 is taxed at the 50% rate,
so you'll pay tax of $20.
The $10 tax deduction reduces your
The $10 tax deduction reduces your income tax
income tax from $25 to $20.
from $25 to $20.
Now 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 your 401k plan
investing in your IRA or your 401k plan,
or paying interest on your home mortgage.
There are also business tax deductions.
There're also business tax deductions.
If I have a business and I make $100
but then I use $10 to pay wages to my employees
to my employees or payelectricity on my building
or pay electricity on my building,
I don't have to pay income tax on the $10
I don't have to pay income tax
on that $10 business tax deduction.
business tax deduction.
Any legitimate business expense is a tax deduction.
Now let's say that youspent $10 of your income
Now, let's say that you spend $10 of your income
in a very favored way according to the government.
in a very favored wayaccording to the government.
Maybe you spend $10
increasing the energy efficiency of your home
the energy efficiency of your home
by putting solar panels on your roof.
You did something the government really wants to encourage.
In this case, the government will give you a tax credit.
So how is this differentfrom a tax deduction?
So how's this difference from a tax deduction?
Again, you compute your taxof $25 on your $100 of income,
Again, you compute your tax of $25
on your $100 in income,
but now the government saysyou spent $10 of your income
but now the government says you spent $10
of your income so well,
so well, you spent it just the same
you spent it just the same as the government would have,
as the government would have,
so what the government says
that you can reduce your $10 directly from your taxes.
your $10 directly from your taxes.
"You owe us $25 in taxes,
You owe us $25 in taxes,
just subtract that $10 tax credit directly
"just subtract that $10 tax credit directly
so you only have to pay $15 in taxes.
"so you only have to pay $15 in taxes."
The $10 tax reductionreduces my taxes by $5.
The $10 tax deduction reduces my taxes by five dollars.
The $10 tax creditreduces my taxes by $10.
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, which should you choose?
Take the tax credit.
I think the tax credit.
But of course, you don't get to make this choice.
the governments consider
Governments consider which activities
which activities they want to encourage
they want to encourage,
and then decide to grant tax deductions
for money spent on those things,
and governments consider activities
that they really want to encourage
and grant tax credits for money spent on those items.