What is a tax credit?

A tax credit is correctly defined as a dollar-for-dollar reduction in the tax owed. This means that when you claim a tax credit, you can directly subtract the amount of the credit from your total tax liability. For example, if you owe $2,000 in taxes and you have a tax credit of $500, your tax liability would be reduced to $1,500.

This direct reduction in tax owed is what distinguishes tax credits from other tax benefits, such as deductions. While deductions reduce taxable income and thereby lower the amount of tax owed indirectly based on your tax rate, a tax credit affects the total tax bill directly, making it generally more beneficial.

In contrast, options that refer to a percentage reduction in taxable income or a form of tax deduction do not accurately capture the essence of what a tax credit is. Additionally, a penalty for late tax payments is unrelated to the concept of a tax credit and involves additional costs rather than benefits.