- Total Income: The Federal individual income tax applies to various types of income including wages; salaries; tips; investment income such as interest, capital gains, and dividends; and noncorporate business income.
- Adjusted Gross Income: After all types of income are totaled up, adjustments are applied that reduce total income for tax purposes, including IRAs, alimony, self-employed health insurance premiums, and some interest on student loans. These adjustments generate the taxpayer’s Adjusted Gross Income (AGI).
- Taxable Income: AGI is then reduced by a “standard deduction” or “itemized deductions,” generating Taxable Income, which is taxed according to the most recent rates enacted by Congress.
- Adjustments to Taxes Owed: The resulting taxes owed can then either be increased by the Alternative Minimum Tax or decreased by certain tax credits such as the child tax credit. Unlike “deductions,” which reduce the amount of income that is taxed, tax “credits” reduce
the amount of taxes owed. Certain tax credits are referred to as “refundable,” which means that if the amount of the credit exceeds the tax bill, the Treasury will make a direct payment of the balance to the taxpayer. In other words, a refundable tax credit can, in addition to erasing one’s tax liability, result in a check from the Federal government. Examples of refundable credits include the Earned Income Tax Credit and the Child Tax Credit. From a budgetary perspective, the amount of the credits that offset tax liability is scored as a revenue reduction, while the amounts that exceed tax liability and are paid directly to taxpayers are scored as budgetary outlays.