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Difference Between Tax Credits and Deductions
Tax credit refers to the amount reduced directly from the total tax liability of the person or corporation. In contrast, tax deductions are deductions that are allowed to be deducted from the total income of the person or corporation, thereby reducing tax liability by decreasing taxable income, not by directly decreasing the tax liability amount.
Tax credits and deductions can aid in reducing the overall income tax liability and is something that all taxpayers want to take advantage of. Tax credits can help to reduce liability at a dollar-to-dollar level but cannot reduce overall liability to less than zero. Tax deductions, on the other hand, lower the taxable income and are calculated using the percentage of marginal tax brackets.
What is Tax Credit?
A tax credit is an amount that can be offset against the overall tax obligation. It is the total amount that an assessee can reduce from the taxes payable to the authorities. Its major benefit is it directly reduces the component of tax liability and is directly measured in terms of the respective currency. There are various types of tax credits available:
- Income Tax Credit: When an assessee is charged tax greater than their actual liabilities resulting from various factors, then the surplus amount is available as a tax credit, which can be carried forward to the following financial year and adjusted against subsequent tax obligations. As an alternative, the amount may be paid, and the excess amount is subsequently credited back to the taxpayer's account.
- Input Tax Credit: This is the credit available to registered dealers and manufacturers for the inputs they purchase to resell. This way, they are encouraged to continue their activities and keep the prices at existing levels or even lower them. Recently, the GST (Goods & Service Tax) passed by the Government of India offers a tax credit to manufacturers paying a GST of 18% or more.
- Foreign Tax Credit: A non-refundable tax credit for income taxes paid to a foreign government resulting from income tax withholdings. The tax credit is available to anyone with investment income from a foreign source or who works in a foreign country. E.g., if a portion of taxpayers foreign income is taxable and some are exempt, the taxpayer must be able to only claim the credit for taxes paid on foreign income.
What is a Tax Deduction?
Tax deductions are qualified expenses that can reduce the gross taxable income (GTI) by a specified amount or percentage. The tax authorities make provisions for the same during the commencement of the financial year.
Assesses can claim deductions on various expenses such as:
- Medical expenses for self and family
- Life Insurance Premiums
- Contribution to funds permitted by the Government
- Donations to institutes permitted by the Government etc.;
For instance, as per the Indian Taxation law, if an assessee invests in Section 80C, which encourages savings associated with Government, the taxpayer does not have to pay any tax on them, and it also reduces their overall taxable income. The limit here is INR 1 50,000, which is eligible to be tax-free.
Tax Credit vs. Tax Deduction Infographics
Let’s see the top differences between tax credits vs. tax deductions.
Key Differences Between Tax Credits and Deductions
- A tax deduction is an eligible expense that reduces the table income of the assessee. In contrast, the tax credit is an incentive whereby taxpayers can reduce the amount of tax under given circumstances.
- A tax deduction is available to the assessee if a specific expense has been incurred. In contrast, tax credit arises if any excess amount of tax has been deposited with the taxation authorities.
- A tax deduction saves the taxation liability by a small amount since the restriction is imposed on the maximum deduction. In contrast, the tax credit is adjusted by a larger and is calculated on a dollar-to-dollar basis.
- A tax deduction reduces the assessee's taxable income, and a tax credit reduces the overall tax liability of the assessee.
Comparative Table
| Basis for Comparison | Tax Deduction | Tax Credit |
|---|---|---|
| 1. Meaning | These are deductions that help in reducing the overall taxable income applicable for tax. | It is a tax incentive whereby the taxpayer is able to deduct the amount of tax under specific circumstances. |
| 2. Benefits | It helps in reducing taxable income. | It is an obligation to pay taxes. |
| 3. Point of Adjustment | Adjusted before application of the tax rate; | Adjusted after the tax due is ascertained. |
| 4. Tax Saving | It reduces tax by a marginal percentage. | The tax reduction applies on a dollar-to-dollar basis. |
| 5. Reason of Existence | It is offered due to a variety of expenses borne by the taxpayer. | It is due to tax already deposited with the tax authorities or specific circumstances. |
Conclusion
Though both these avenues help reduce the tax burden for any taxpayer, the advantages offered are different, and one should take advantage of them accordingly. A tax deduction is offered to many people and will have a minimal impact. On the other hand, the tax credit offers a precise amount of money for any excess tax paid retrospectively. Thus, the pros and cons should be ascertained accordingly.
