My son lived all year in NJ but worked all year in NY. The NJ return acknowledges the correct tax amount paid to NY. I expected that amount to be the tax credit for NJ, but the NJ return multiplies the amount by a "maximum allowable credit percentage" (85%) and applies that result as the tax credit. Apparently that's because NJ will not credit a NY tax amount which is greater than what NJ would have taxed on that amount of income.
The result of this, it seems to me, is that he is ending up paying all of the NJ tax owed on that income plus the 15% of the tax paid that was to NY. I hope that I am misunderstanding this.
Nope. You got it. New Jersey gives credit only for the amount of tax that you would have paid if you had earned the income in New Jersey. No more.
Here's New Jersey's publication on it.
They call it "minimizing" double taxation.
Let's say that the NY tax on a certain salary income is 10K, and so NY witholds that's amount.
In NJ, the tax on the same income is only 8K, so NJ gives a credit for only 8K. What happens to the 2K that NY withheld?
It stays in New York. The NJ credit minimizes double taxation of income that is already taxed by other jurisdictions, in your case, NY.
Here is a Community Discussion that may help.