Wednesday, January 25, 2012

President proposed granting many Tax Credits to various businesses. Why not Tax Deductions instead? Brief explanation here as to why...

In the State of the Union Address the President spoke of  granting "Tax Credits" for various private sector investments.  Why did he not say "Tax Deductions"?  Many people do not completely understand the difference. Let me use a simple example to illustrate the difference.
Below is some simple data.  Assume this represents a very small business operated by a single person.

Income from the business:     $100,000
Qualified Tax Deductions:      - $20,000
Net income to be taxed:           $80,000
Tax Rate: 25% (guesstimate!)
Income Tax Paid  (.25 x $80,000)       $20,000   
All individuals and/or businesses qualifiy for various Tax Deductions that are worth different dollar amounts.  For a business, examples would be expenses such as wages paid to workers and other costs of producing a good or service.  Deductions effectively reduce the amount of income that is subject to taxation.  In this example, the business pays $20,000 in income tax based on a gross income (revenue) of $100,000. 
Now assume the President proposes giving this business and additional "Tax Deduction" of $10,000 to purchase a $10,000 piece of equipment.  This will help the business owner reduce the cost of purchasing the equipment by reducing their taxable income:

Income from the business:   $100,000
Qualified Deductions:             -$20,000
Additional Deduction:            - $10,000
Net income to be taxed:          $70,000
Tax Rate:        25%
Income Tax Paid:                      $17,500

Now the business owner only pays $17,500 as opposed to $20,000 in income taxes. Effectively that $10,000 piece of equipment cost the business only $7,500. Good Deal! 
Now, assume instead of a Tax Deduction the business is granted a TAX CREDIT:
Income from the business:   $100,000
Qualified Deductions:            - $20,000

Additional Purchase:               -$10,000
Net income to be taxed:          $70,000
Tax Rate:        25%
Income Tax :                              $17,500
TAX CREDIT:                             -$10,000
Income Tax Paid:                        $7,500

Notice the difference.  A Tax Credit is a dollar for dollar subtraction  from Income Tax owed, whereas the Tax Deduction reduced the amount of income subject to taxation. 

Please note:  I used a dollar-for-dollar amount for the Tax Credit when this business bought a piece of equipment, so the outcome in the reduction in taxes owed was quite dramatic.  This is an unlikely scenario and the amount of the Tax Credit would probably be capped at a some percentage of an equipment purchase and/or at a maximum dollar amount.

However, the point is the same. It is generally better to get a Tax Credit as opposed to a Tax Deduction.  The tax credit incentivizes a business to purchase equipment it might want to purchase or it accerlates forward the replacing of old equipment. Either way, it encourages the purchase of capital goods, hence encourages the production of those capital goods and away the economy goes...At least that is what is SUPPOSED to happen...

Hopefully this helps. If anyone sees a mistake in my math or methodogy, please let me know. Thanks!

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