What is the Difference Between Tax Deductions and Tax Credits?: An Explainer

Photo by Markus Winkler on Unsplash
2 September 2021
By D.T. Cochrane
 
 
Often, when someone in Canada refers to a “tax deduction” what they actually mean is a “tax credit.” This habit is so common that it even showed up in the Conservative Party’s election platform, as pointed out by economics professor Lindsay Tedds.
 
The ultra-quick explanation is that deductions reduce the amount of income that the government uses to calculate how much tax you owe, while credits reduce the amount of taxes you have to pay. [1]
 
Let’s break it down...
 
(In the following explanation, key terms that appear in the T1 Income Tax and Benefit Return are bolded and italicized in their first use.)
 
 

What are deductions?

On Canadian tax forms, “deductions” refer to your income, not your taxes. Deductions reduce the amount of your taxable income. In other words, you don’t get a deduction to your tax bill, you get a deduction on the income that gets taxed.
 
To calculate your taxable income, deductions are applied in two stages. [2]
 
STAGE 1: The first stage of deductions are applied to your total income. These deductions include things like childcare expenses, moving expenses, and interest expenses. Your net income is total income minus any eligible deductions in the first stage.
 
STAGE 2: The second stage of deductions primarily includes money lost on investments, as well as for Canadian Forces and police personnel deployed on riskier missions, plus deductions for Northern residents. Net income minus any second stage deductions results in what is called your taxable income. [3]
 
In other words:
  • Total income minus stage 1 deductions = Net income.
  • Net income minus stage 2 deductions = Taxable income. 
If you do not have any Stage 1 deductions, then your total income will equal your net income. If you do not have any Stage 2 deductions, then your net income will equal your taxable income.
 
 
COMPARATIVE EXAMPLE:
 
Tanis Tarantula and Joel Jackrabbit are two Canadian workers. In 2020, they both had a total income of $52,000.
 
Tanis incurred $2,000 in expenses when she moved to be closer to a new job. She got to deduct that amount from her total income. That means her net income was down to $50,000. 
 
Joel has no Stage 1 deductions, so his net income was the same as his total income: $52,000.
 
Joel lives in Whitehorse. That means he qualified for the Northern residents deduction, a Stage 2 deduction. He fills out the form for this deduction and is able to claim $4,000. 
 
Tanis had no Stage 2 deductions.
 
So, Joel’s taxable income was $48,000, while Tanis’ was $50,000.
 
 
Tanis Tarantula
Joel Jackrabbit
Total income
$52,000
$52,000
Deductions, Stage 1
$2,000
-
Net income
$50,000
$52,000
Deductions, Stage 2
-
$4,000
Taxable income
$50,000
$48,000
 
 

What is “gross tax”?

As described in our tax bracket explainer, taxable income is split into brackets, and different tax rates are applied to the amounts in each bracket.
 
Once applicable rates have been applied to each segment of your taxable income, the total dollar amount of tax before any tax credits are applied is what we are calling your “gross tax”. [4] (Gross tax is also the term for the amount that you would owe if you had no tax credits at all.)
 
 
Returning to our EXAMPLE:
 
Tanis’ taxable income of $50,000 put the very top amount of her income into the second bracket. That means her gross federal taxes were 15% of the first $48,535, plus 20.5% of the remaining $1,465, for a total of $7580.58. [5]
 
Joel’s $48,000 in taxable income was entirely within the first bracket, so his gross federal taxes were calculated at the rate of 15%. His gross tax will be $7,200.
 
 
 

What are tax credits?

You can reduce the amount of tax that you will actually pay by applying tax credits to the amount of gross tax.
 
Think of it like this: You owe a friend $100. However, they say, “Hey, I’ll knock $50 off of what you owe me if you help me move this couch.” You earned credit for moving the couch that you get to apply against the money you owe your friend.
 
One reason our tax forms look so complicated is the plethora of various tax credits.
 
Everyone has at least one tax credit: the basic personal amount (or BPA).
 
 
Let’s return to our EXAMPLE:
 
Tanis and Joel both earned all of their income through employment. They also made maximum contributions to Employment Insurance (EI) and the Canada Pension Plan (CPP).
 
When filing their federal taxes, both Tanis and Joel claimed the maximum BPA, which was $13,229 in 2020. [6]
 
Tanis and Joel also got to claim credit for their EI and CPP payments. EI and CPP contributions are based on insurable income, which we assume is equal to their total income. The credits were equal to $2,730 for CPP and $821.60 for both Tanis and Joel. [7]
 
These amounts are summed and then multiplied by 15% to get Tanis Tarantula and Joel Jackrabbit’s total federal non-refundable tax credits: $2,517.09. [8]
 
Gross tax minus non-refundable tax credits equals the basic federal tax.
 
In this simplified example, we are jumping over other types of credits that can reduce your final tax bill. This means Tanis and Joel’s basic federal tax equals their federal tax, which equals their net federal tax.
 
 
Tanis Tarantula
Joel Jackrabbit
Gross tax
$7,580.58
$7,200.00
Total federal non-refundable tax credits
$2,517.09
$2,517.09
Net federal tax
$5,063.49
$4,682.91
After deductions and applicable tax credits, Tanis has an effective federal tax rate of 9.7%, while Joel’s effective rate is 9%.
 
 
 

Summary

Our tax system is complex. It is understandable when the public conflates credits and deductions. But the distinction matters beyond the small circle of wonky tax nerds. 
Taxes are also a political battleground. If a government wants to increase or reduce taxes, they can add, remove, or change either deductions or credits. Either way, the decision will affect you as a taxpayer, the amount of revenue the government can generate, as well as income distribution. The better we understand that, the better equipped we are to assess the government’s tax plans.
 
 
 

Endnotes

[1] Our tax system used to include more deductions. However, because a deduction reduces the amount of taxable income used to calculate taxes owing, they are more valuable to those with higher incomes. For that reason, many previous deductions were turned into credits.
[2] The two stages of deductions exist because net income and taxable income get used for different purposes throughout our tax system. Most notably, tax rates are applied to taxable income. However, the details of these different uses are beyond the scope of this explainer.
[3] Note that this describes the federal forms, which are then used for calculating both federal and provincial taxes, except in Quebec. However, the basic structure—total income > net income > taxable income—is the same for Quebec provincial tax forms. 
[4] The CRA does not have a label for this amount.
[5] All sample values for the BPA, CPP, and EI are based on the 2020 tax year. The BPA is increased every year and is currently scheduled to be $15,000 in 2023.
[6] The maximum BPA can be claimed up to a net income of $150,473. Above a net income of $214,368, the BPA is $12,298. There is a sliding scale between these upper and lower bounds.
[7] There are maximums to the amount of insurable income eligible for CPP and EI. In 2020, the CPP maximum was $58,700. The EI maximum was $54,200.
[8] Non-refundable tax credits mean that if the credits sum to more than your gross tax, you do not receive any additional money refunded. Conversely, if the value of all your refundable tax credits is more than your gross tax, you will receive money from the government. In a subsequent explainer we will look more closely at the distinction between non-refundable and refundable tax credits.

 

 

{Photo by Markus Winkler on Unsplash}