What is a tax credit?

A tax credit is defined as an amount subtracted directly from the tax owed. This means that when an individual or business calculates their taxes, they can deduct the value of the tax credit directly from the total amount of tax they need to pay, effectively reducing their tax liability. This is distinct from tax deductions, which lower taxable income rather than the tax owed. Tax credits can be based on various factors, such as educational expenses, energy-efficient home improvements, or specific business investments, making them an attractive way for taxpayers to lower their tax bills.

In contrast, the other options don't accurately describe what a tax credit is. Adding an amount to taxable income would increase the tax owed, modifying the interest rate on a loan is unrelated to tax obligations, and an obligation to pay a specific amount of tax refers to the total tax liability itself, not a reduction or credit against that liability. Hence, understanding that a tax credit is a direct reduction of the tax owed provides clarity on its significance in tax planning and financial management.