Marginal Tax Rates, Tax Credits, and Tax Deductions: The Basics of Computing a Tax Liability
This comment introduces readers to the calculation of tax payable under Part 1 of the Income Tax Act, and the difference between tax deductions and tax credits.
Generally, all income earned from employment, business, or a property is taxable. Any income earned in the course of business and employment, and from a property must be declared. The Income Tax Act provides for many tax deductions that a taxpayer subtracts from their source income, so the declared income is a net concept generally.
Once a taxpayer determines their income and makes the appropriate tax deductions, the Income Tax Act (“ITA”) under s.117(2) applies five marginal tax rates to different ranges of the taxpayer’s income, to determine the tax payable under Part 1 of the ITA. The brackets are the following:
- 15% for the first $45,282 of taxable income,
- 20.5% for the next $45,281 of taxable income,
- 26% for the next $49,825 of taxable income,
- 29% for the next 59,612 of taxable income,
- 33% for any income above $200,000.
Note, these brackets change annually, according to the adjustment formula in s.117.1(1), which uses the Consumer Price Index to adjust the range of income to which each bracket applies. The sum of the amounts obtained by multiplying each marginal tax rate specified in s.117(2), against the applicable part of the taxpayer’s income, if any, is the maximum tax payable under Part 1 of the ITA.
This maximum amount will include any tax deductions that apply to the taxpayer’s circumstances. The subsequent application of available tax credits will change the taxpayer’s final tax liability by adjusting the maximum tax payable.
That is, tax deductions and tax credits will affect the calculation of a tax liability in different ways.
Deductions vs Credits
One can think of the difference between tax credits and tax deductions from an accounting perspective. A tax deduction is a top-line deduction from taxable income, and a tax credit is a bottom-line deduction from tax payable. Consider the following accounting statement:
Tax Deductions: $20,000
Taxable Income: $80,000
Assuming a single tax rate of 15%, one would multiply 15% by $80,000 to get tax payable:
Tax Payable (15%): $12,000
If the taxpayer has a $1,000 tax credit, then one subtracts $1,000 from tax payable:
Tax Payable: $12,000
Tax Credit: $1,000
Net Tax Liability: $11,000
Net Income: $59,000
Notice that one subtracts tax deductions from the Revenue amount at the top of the statement. On the other hand, tax credits affect the tax payable, which is at the bottom of the statement. This difference in application is what the reference to “top-line” and “bottom-line” means. Tax deductions reduce taxable income, and tax credits reduce tax payable.
The effect of tax credits and tax deductions is different because they affect different parts of a taxpayer’s income statement. Since tax deductions occur at the top of the income statement, their value is a function of the taxpayer’s actual income. If the taxpayer is in a high tax bracket, the tax deduction is more valuable to the taxpayer relative to a taxpayer that is in a lower tax bracket, all other things being equal in a progressive tax system. If the taxpayer is in a lower tax bracket, the deduction is less valuable.
As an example, consider taxpayer A, who pays 29% in marginal tax, earns $100,000, and has a deduction of $10,000, and consider taxpayer B, who pays 15% in marginal tax, earns $40,000, and has a $10,000 deduction. Without the deduction, taxpayer A pays $29,000 in tax. The deduction will reduce the tax payable to $26,100. The amount of income saved by the deduction is $2,900, or $10,000 times 29%. On the other hand, taxpayer B will reduce tax payable by only $1,500 using the same $10,000 tax deduction, which is 15% times the $10,000 deduction. Notice that in each case, the amount of tax savings is equal to the deduction amount multiplied by the taxpayer’s marginal tax rate. Thus, the more income a taxpayer has in a progressive tax system, the more valuable a tax deduction becomes.
From the above example, one can see that tax credits work by directly reducing a taxpayer’s tax payable, by the value of the tax credit. One deducts the absolute value of the tax credit from tax payable regardless of the marginal tax rate that applies. In other words, the tax credit has a value of $1,000 for taxpayer A, who pays 29% marginal tax rate, and for taxpayer B, who pays 15%. The $1,000 tax credit will reduce both tax payable amounts by $1,000.
It should be noted as well that the tax credit system is, in my view, comparatively more complex than the tax deduction system, because tax credits exist generally to promote some economic or social policy. Each one has a different purpose and applies in a specific set of circumstances. For example, the Basic Personal Amount under s.118 is available to all Canadian resident individual taxpayers, but the Foreign Tax Credit under s.126 is available only to resident taxpayers who paid tax to a foreign government. And whereas all tax paid to a foreign government results in a tax credit amount, tax credits like the Basic Personal Amount will be, in contrast, a fixed amount specified in the ITA that is multiplied by the “appropriate percentage” to obtain the tax credit amount for these latter types of tax credits. To add to the fun, the Foreign Tax Credit is called the “foreign tax deduction”, because it operates like a tax deduction applied at the bottom of the income statement.
Other complexities are the non-refundable/refundable distinction, which determines whether a tax credit can reduce tax payable below zero, leading to a tax refund; or things like the “appropriate percentage” itself, which is the rate used to calculate the tax credit and is the lowest amount specified in s.117(2) (15%). Such complex nuances are part of the joy of tax law.
The Basics of Computing A Tax Liability
Assuming the taxpayer earns only income, one can think about computing a tax liability in general terms as a three step process: 1) determine the income from a source, 2) subtract permissible deductions, and 3) subtract applicable tax credit amounts. The final amount is the taxpayer’s tax liability.
The CRA provides a list of all tax credits, deductions, and expenses here.
Disclaimer: This article is not advice. It is intended to be a basic overview of the general steps in computing a tax liability. Readers should seek help from a tax professional if they are solving a legal problem.