Which of the following best defines a tax credit?

A tax credit is best defined as a direct reduction in tax liability. This means that when a taxpayer qualifies for a tax credit, it directly decreases the amount of tax owed to the government, dollar for dollar. For example, if a taxpayer has a tax liability of $1,000 and qualifies for a $200 tax credit, their final tax liability would be reduced to $800.

In contrast, a reduction in taxable income lowers the amount of income that is subject to taxation, which may sometimes lead to a reduction in overall tax liability but is not the same as a tax credit. An increase in tax rate would raise the amount owed and is not beneficial in any way to the taxpayer. A penalty for late tax payment imposes additional costs on taxpayers who fail to pay their taxes on time, which has no relation to tax credits. Thus, the definition that captures the essence of tax credits accurately is the one that states they are a direct reduction in tax liability.