Lessons · Accounting · a deduction reduces what is taxed, not the tax
A deduction reduces what is taxed, not the tax
A deduction comes off income before the rate is applied, so it saves tax at your rate rather than saving its own amount. A credit comes off the tax itself. Confusing the two overstates the value of a deduction by a large multiple.
Hone is a place to practise a career, one idea a day. This is one of its lessons, written out in full and free to read without an account.
In beta. This lesson was written for Hone and has not yet been checked by a qualified accountant. Practice material, not professional advice. What that means.
What it is for
It is the arithmetic behind a great deal of bad advice. Somebody is told an expense is deductible and believes it is therefore free, and spends money to save tax, which is only ever sensible if they wanted the thing anyway. The saving is a fraction of the spend, and knowing which fraction is what makes the decision honest.
How to think about it
For a deduction, multiply the amount by the marginal rate to find what it actually saves. For a credit, the saving is the credit. Then ask whether the spend was worth making for its own sake.
Worked example
A deduction of an amountComes off income before the rate.
Saves that amount times the marginal rateA fraction of the spend, never all of it.
A credit of the same amountComes off the tax itself.
So a credit is worth more than a deduction of the same sizeUsually by a lot.
Your turn
Name what a deduction is multiplied by to find what it saves.
A deduction saves its amount times your rate
Solve one, graded on the server
The trap
Spending to save tax. The saving is a fraction of the spend, so it leaves you poorer unless you wanted the thing regardless, and the advice to buy something before the year end is usually worth checking with this arithmetic.