There is a great misconception when it comes to tax deductions versus tax credits and I find this to be true whether one is dealing with a Canadian taxpayer or an American taxpayer. Every year, without fail, I will meet someone who expects to get money back because they donated for example or the person who thinks that his or her donations will reduce taxable income altogether.
In general, a deduction is used to lower income before it is taxed (deductions are applied before arriving at taxable income). A credit is applied to the taxable income. Often, a credit gets applied at the lowest tax rate. The credit that gets applied at the highest tax rate regardless of income is the donation. In Canada, donations worth more than $200.00 will earn a higher tax credit – generally the second highest tax bracket – unless you are in Trudeau’s 33% bracket.
Politicians of all stripes like to excite Canadians by announcing the dollar value of the starting point of a particular credit, not the real dollar value of the credit. For example, I will use the “Home Buyer’s Amount” that was announced as $5000.00 for the purchase of your first home. The way it truly works is $5000.00 x15% = $750.00 – please note that 15% is the lowest federal tax bracket.
If the Home Buyer’s Amount were a deduction instead of a credit (which it is not), an example could be this. If you are in the 26% bracket federally than you would save $5000x 26% = $1300 – please note that this would be the exact same result if the credit percentage were tied to the taxpayer’s bracket given in the example. In this case it would not matter if it were a deduction or a credit. It is important to emphasize here, however that most credits are based on the Lowest tax bracket which is currently 15%.
When politicians talk, they like to announce credits that they call often call tax breaks – but remember you have to spend the money first and than you get rebated a percentage back, as stated before, and this cannot be emphasized enough – at the lowest bracket, regardless of which bracket, you actually fall in, with a few exceptions. They have gotten away with this for a very long time. They take advantage of the situation, and sadly the situation is that most people do not understand the difference between a deduction and a credit, and they like it like that.
To add to it all – most credits are non-refundable which basically means that you do not get a credit out of the tax system unless you actually put into the tax system. We do have a few refundable credits where one can get a refund, even without putting into the system in the first place – these are few and far between such as the “Refundable Medical Supplement”. I will speak about these two types of credits in a different post using the classic tale of a welfare recipient who believes that donations do more than provide a warm feeling that you are contributing to society – the recipient who thinks he gets money back as a result of the donations.
If you are in the lowest tax bracket, this does not make a difference to you, but, if you are in any other tax bracket it should.
Thank you. This is super helpful for me!
Glad this was helpful – will have more like this in the near future.
Solid advice man. Do you in your opinion think shifting small business deductions to personal credits on a government level would be good for the people of canada in the long run or make the economy worse?
I believe that the small business deduction is good for corporations but it cannot be shifted to a personal credit because of the case of the two separate entities, hence the potential problem with corporate / personal integration. As you may know the small business deduction keeps corporate income at the lowest tax bracket as far as the corporation is concerned. To achieve what I believe you are asking, and please correct me if I’m wrong, is to allow the first $500 000 to be taxed at the lowest bracket or 25% in Alberta (on business income) – this would achieve the same result and it would be good in my opinion for the Canadian economy in the long run as people would have more money to spend on their needs and wants as purchasing power would increase thus allowing more jobs to be created as well. Equally important, it would create incentive to work harder – there is no incentive in making this kind of money to give the government up to 48% in tax on top of Canada Pension Plan (CPP) contributions when doing business as a sole proprietor / independent unincorporated contractor. Some may argue that such a move may make the economy worse since there would be less tax dollars to pay for social programs – I believe they should be there for the few who may genuinely need them (not everyone currently on them), but these programs are being eroded by government stupidity anyways and if people are allowed to keep more of their money it probably would stimulate the economy in ways we haven’t seen in a while.
thank you very much for making this clear to understand