Which statement describes a tax credit?

• A. A deduction reduces taxable income
• B. A deduction reduces tax payable directly
• C. A credit reduces taxable income
• D. A credit reduces tax payable directly

Answer: (D)

A tax credit directly reduces the tax you owe. After your tax is calculated, a credit subtracts from that amount, dollar for dollar. For example, if your tax due is $2,000 and you have a $500 credit, you pay $1,500. Deductions, on the other hand, lower your taxable income, which then reduces tax payable by applying your marginal tax rate to that smaller amount. So a deduction saves tax based on your rate, not as a direct subtraction from the tax bill. A credit does not reduce taxable income, and a deduction does not reduce tax payable directly. Therefore, the option stating that a credit reduces tax payable directly is the correct one.