With all this talk about tax reform it’s advantageous to get a refresher on basic tax lingo. Specifically, it’s a good start to know the difference between a tax deduction and a tax credit. The concept is simple enough but the reasoning behind taking away a tax credit or tax deduction makes all the difference when talking about tax reform.

Tax Deductions

A tax deduction is not a dollar for dollar deduction of tax liability but instead a dollar for dollar reduction in taxable income. They really should be called income deductions but that just sounds odd. Common deductions are the mortgage interest deduction, student loan interest deduction, state and local income tax deduction, property tax deduction, etc.

To get a general understanding of how a deduction impacts tax liability you can simply multiply your marginal tax rate by the tax deduction. For example, lets say you take a $1,000 deduction for student loan interest. Assuming that you are in the 25% income tax bracket, that $1,000 deduction will save you $250 is taxes ($1,000 x .25 = $250).

Tax Credit

A tax credit is a one-to-one reduction in tax liability. These are especially potent because a $1,000 credit saves you exactly $1,000 in tax while a $1,000 deduction only nets you a fraction of that amount.

Some examples of tax credits are the child tax credit, the earned income credit, the lifetime learning credit, and the foreign tax credit. Some of these credits are refundable meaning that you will take advantage of the full tax credit even though your tax liability is zero.

For example, lets say your withholding for the year is $5,000 and you’re eligible for a $1,000 refundable tax credit. Assuming your tax liability is zero, then you should be entitled to a refund of $5,000 in withholding plus the $1,000 refundable tax credit. If the credit is non-refundable then you will only be entitled to a $5,000 refund instead of the $6,000 refund if the credit was refundable.

Why It Matters

The distinction between a tax deduction and a tax credit is huge – especially for policy experts shaping potential tax reform. Tax deductions and tax credits impacts taxpayers differently and may be more or less equitable depending on how they are deployed.

Lets start with tax deductions and why it matters for tax reform. The major complaint for tax deductions is the fact that they aren’t equitable for all taxpayers which is mostly due to varying marginal tax rates.

For example, a $1,000 deduction for a taxpayer whose marginal tax rate is 39.6% will net a $396 tax savings. Meanwhile, a tax deduction for a taxpayer whose marginal rate is 25% will yield a $250 tax savings. So even though both taxpayers received the same reduction of taxable income, their tax savings are not the same.

This is why tax reform aims to eliminate many if not all itemized deductions. The reasoning behind this is quite simple – higher income individuals have larger tax deductions and the impact is far greater with higher marginal tax rates.

Tax Credits are More Progressive

Another sticking point for tax reform is the enhancement of specific tax credits to makeup for the elimination of certain tax deductions. For example, the proposed legislation looks to eliminate the personal exemption and replace it with an increased child tax credit.

Tax credits are more progressive than tax deductions because they are not dependent on the marginal tax rate of the taxpayer. If anything, higher income earners will not benefit from tax credits at all because these credits usually phaseout as income increases.

What It All Means

Most economists and tax analysis agree that the elimination of tax deductions coupled with reductions in income tax rates is more equitable. Add some enhanced tax credits and you’ll ensure that lower-income individuals won’t be adversely impacted by tax reform. However, there will always be a subset of taxpayers who will be hurt by the elimination of deductions, namely homeowners in high taxed states like New York, New Jersey, California, and Illinois.