The Earned Inome Tax Credit (EITC) - a credit, not a deduction

A tax credit reduces tax payments dollar for dollar. A tax deduction, by contrast reduces taxable income dollar for dollar. A deduction’s impact on tax liability depends on the taxpayer’s marginal tax rate—the lower the rate, the less the tax reduction.

The lowest federal income tax rate in tax year 2017 was 10 percent. It applied to joint returns with taxable income under $18,650. For taxpayers in this bracket, a $1,000 deduction lowers tax liability by $100 (10 percent of $1,000), while a $1,000 credit lowers tax liability by the full $1,000.

EITC is a refundable tax credit. Refundable tax credits can generate a negative income tax liability, where the taxpayer’s income tax refund exceeds his income tax payment. In this way, refundable credits are a form of negative income tax.

The following example highlights the difference between a refundable credit like EITC and a tax deduction of equal amount.

Assume a family with two children has taxable income of $18,000. Their federal income tax liability is $1,800 (10 percent of $18,000.)

A $4,000 tax deduction reduces the family’s taxable income to $14,000, and cuts its tax liability to $1,400—a reduction of $400.

A $4,000 refundable tax credit reduces the family’s tax liability by $4,000. This is more than the family’s tax bill. So after paying taxes of $1,800, the family receives a check for $4,000. Their net tax payment is therefore negative $2,200.

Bottom line: A $4,000 deduction reduces this family’s tax liability from $1,800 to $1,400. A $4,000 refundable credit eliminates the family’s tax liability completely, paying them $2,200 over and above the $1,800 they paid in taxes.