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What Exactly is a Tax Credit?

It would be so much easier to make smart voting decisions if we could just get a simple rundown of what each policy means, how much it would cost taxpayers, and how that money would help Missouri.

A tax topic of much contention right now is Missouri tax credits. Tax credits aren’t just controversial; they’re highly complex. Tax credits can benefit individuals or businesses, and they’re offered both by the federal government and the state of Missouri.

Each tax credit the state offers to individuals or businesses means less direct tax revenue for the state. Usually, tax credits are offered as a longer-term investment in things like attracting (and keeping) businesses in the state.

In the months ahead, we’ll be talking a lot on the Missouri Parent Blog about tax credits. Today we’re here to lay the foundation for those conversations by answer the question, “what exactly is as tax credit?”

Wikipedia calls a tax credit “a sum deducted from the total amount a taxpayer owes to the state,” and The Internal Revenue Service (IRS) defines a tax credit as “a dollar-for-dollar reduction in the tax. Can be deducted directly from taxes owed.”

Tax credits are easily confused with tax deductions, but they aren’t the same thing. According to the IRS, a tax deduction is “an amount (often a personal or business expense) that reduces income subject to tax.” (source)

While tax credits are taken dollar-for-dollar from the total taxes owed by an individual or business, tax deductions are a less direct way to reduce tax responsibility.

What do you mean, “dollar-for-dollar”?

A tax credit is an amount of money that’s subtracted from the total taxes due to the state. If a business owes $10,000 in taxes and receives a $1,000 tax credit, the equation looks like this:

$10,000 due - $1,000 tax credit = $9,000 due

Think of a tax credit as a coupon for a certain number of dollars off a total grocery bill (for example, $25 off your grocery bill). That credit/coupon is applied to your total bill upon checkout. No matter how much you spend, you still save $25. If you spend less than $25, however, you don’t get a refund – you simply walk away with a zero balance.

This example is simplified and shouldn’t be taken literally. The point that it illustrates, though, is that tax credits are a dollar-for-dollar discount on taxes due.

Tax Credits & Tax Deduction Both Equal Tax Savings

Deductions and credits can both reduce the overall taxes owed by an individual or a business, but deductions reduce the taxes owed in a way that’s relative to both the taxpayer’s gross income and their tax bracket.

The TurboTax Blog sums it up nicely:

“A tax deduction is something that reduces how much taxable income you claim. A tax credit is something that directly reduces how much tax you owe.” (Source)

Here are two detailed examples of how a $1,000 tax credit and a $1,000 tax deduction would impact taxes owed:

Example 1 – Tax Credit: Let’s look back at the above example. Imagine that you received a $1,000 tax credit for your business. This tax credit will be applied dollar-for-dollar to the state taxes you owe on April 15th.

If your total amount of taxes due to the state total $10,000, you’ll subtract $1,000 from that. Your actual taxes owed are reduced to $9,000.

$1,000 Tax Credit = $1,000 in Tax Savings

Example 2 – Tax Deduction: Now, imagine that your family is in the 25% tax bracket, earning $50,000 per year. You receive a tax deduction for $1,000. Your tax bracket (25%) is multiplied by the value of the deduction ($1,000) to find your actual tax savings of $250.

$1,000 Tax Deduction x 25% Tax Bracket = $250 in Tax Savings

(Source)

Summary
Tax credits are dollar-for-dollar reductions in the total amount of taxes an individual or business owes to the state. The value of a tax credit can be taken at face value; a $1,000 tax credit means that the total taxes due are reduced by $1,000. Tax credits are offered to individuals and to businesses at both the state level and the federal level (i.e. on Missouri state and federal taxes).

The Missouri Parent Blog will explore tax credits in more detail in the weeks and months to come. Please bookmark the Missouri Parent Blog or follows us on Facebook and Twitter to stay up-to-date on policy and funding issues affecting Missouri public schools, and for insights on helping your child succeed in school.



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