Question

Tax Credit v. Deductions

There is an important distinction between tax credits and tax deductions.
_____ reduce taxable income on which the tax liability is based. _____ reduce the tax liability dollar for dollar

A) Tax credits reduce taxable income on which the tax liability is based. Tax deductions reduce the tax liability dollar for dollar.
B) Tax credits reduce the tax liability dollar for dollar. Tax deductions reduce taxable income on which the tax liability is based.
C) Tax credits reduce the tax liability dollar for dollar. Tax deductions reduce taxable income on which the tax liability is based.
D) Tax credits reduce taxable income on which the tax liability is based. Tax deductions reduce the tax liability dollar for dollar.

Answer 1

The difference between tax credits and tax deductions is that deductions lower the taxable income while credits reduce tax liability dollar for dollar. Option B is correct: Tax credits reduce the tax liability dollar for dollar, while tax deductions reduce taxable income.

Step-by-step explanation:

The correct answer to the distinction between tax credits and tax deductions is option B. Tax deductions reduce taxable income, which is calculated by subtracting deductions and exemptions from the adjusted gross income. Reducing taxable income lowers the base on which tax liability is calculated but does not directly reduce the tax payment dollar for dollar.

On the other hand, tax credits provide a dollar-for-dollar reduction in tax liability, meaning that each dollar of tax credit reduces the amount owed in taxes by one dollar. Tax credits can be more valuable than deductions because they reduce the tax liability directly rather than just lowering the income that the liability is based on.