Scholarship tax-credit policies make it possible for low-and-middle-income families in 18 states to enroll their children in a private school – something only wealthy families had previously been able to afford. Since we’re committed to bringing such a policy to Kentucky, taxpayers in the commonwealth need to fully understand what the policy is – and is not – and how it works.
For example, it’s important to understand the difference between a tax deduction and a tax credit, and why a tax-credit policy offers a more-attractive incentive for businesses and individuals to donate to scholarship programs.
So, what’s the difference?
Tax deductions reduce how much income is subject to being taxed while a tax credit reduces the total amount of taxes owed.
For example, let’s say your income is $100,000 per year and your tax bracket is 40% (for easy round numbers). Without taking any deductions or credits, you would owe $40,000 in taxes. (Fig 1.)
However, consider how your taxable income changes if you make a $1,000 charitable donation that’s tax-deductible.
The $1,000 donation comes directly off of your taxable income (Fig 2). If you’re still in the 40% tax bracket, you’re now taxed on $99,000 instead of $100,000, meaning you owe $400 less than if you had not taken the deduction.
However, if instead you were able to take a tax credit, your taxable income would stay at $100,000 but your tax liability would be $1,000 less (Fig 3).
So, the $40,000 you owed in the first example is now $39,000 because the $1,000 donation comes directly off the amount you owe. A tax credit means you pay $600 less in taxes on a $1,000 donation than you would with a tax deduction, making a tax credit far more desirable.