Business, Legal & Accounting Glossary
A tax credit is a direct reduction in the amount of taxes owed by a taxpayer. For example, if a taxpayer owes $1,000 and is allowed to claim a $100 tax credit, the post-credit amount owed becomes $900. A tax credit is distinct from a tax deduction in that the latter reduces the amount of taxable income a taxpayer must report. Because taxes are calculated as a percentage of income or revenue, the size of a tax deduction would have to be larger in order to achieve the same dollar-for-dollar reduction in taxes owed as a tax credit. Consequently, tax accountants tend to view a tax credit as more valuable than a tax deduction. A wide variety of tax credit options are available to individuals and businesses. For example, in 2009, the federal government established a temporary tax credit for first time home buyers. Other examples include the health care tax credit for small businesses, the earned-income tax credit, child care tax credit, and energy efficiency tax credit to homeowners offered by both the state and federal government.
Within the United States, Canadian, Australian and United Kingdom tax systems, a tax credit is an item which is treated as a payment already made toward taxes owed. It has the effect of reducing tax liability dollar-for-dollar, in contrast to a tax deduction, tax allowance or tax relief which reduce taxable income, not tax liability
Tax credits may be characterized as either refundable or non-refundable or equivalently non-wastable or wastable. Refundable or non-wastable tax credits can reduce the tax owed below zero, and result in a net payment to the taxpayer beyond their own payments into the tax system, appearing to be a moderate form of negative income tax. Examples of a refundable tax credit include the earned income tax credit and the additional child tax credit in the US, and the working tax credits or child tax credits in the UK
A non-refundable or wastable tax credit cannot reduce the tax owed below zero, and hence cannot cause a taxpayer to receive a refund in excess of their payments into the tax system. Some example of non-refundable tax credits tax credits are the Hope and Lifetime Learning educational tax credits in the US or the former children’s tax credit in the UK.
Tax credits may be given to employers to encourage them to pay employees more. In the United Kingdom, employers do not pay for either the ‘Child Credit’ or ‘Working Tax Credit’ but are expected, instead of paying the amounts due to the Inland Revenue, to give it directly to their employees. Single low earners working over 16 hours per week and couples working 30 hours combined are eligible. If one supports children, the supplements are greater. Two issues are being addressed, the so-called employment and poverty traps. That means the disincentive to work when expected wages are little more than unemployment benefits, and the difficulty for workers to break above a net earning margin faced with not just income tax, but national insurance, VAT, student loan repayments and other cumulative tax burdens.
This indirect wage regulation forms an important part of income for low earners and their families. It reduces the stigma of collecting benefits for workers and perhaps even shifts it to employers, who become very aware they are giving staff low pay. It is not a direct cost to employers in the way an NMW is, but in some cases, it has been found that employers put pressure on workers to do fewer hours to avoid extra tax forms. So it should be questioned why simply raising the personal allowance can not do the same for single workers with a reduced administrative burden for both employers and HMRC.
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This glossary post was last updated: 22nd March, 2020