Damned if you do, damned it you don't; tax specialist Terry Baucher recounts the twisted tax tale of Morton's fork and how it applies in NZ. Your view?

By Terry Baucher*

When Henry VII, Henry VIII’s father, became king at the end of the War of the Roses, the Crown was very nearly bankrupt.  Ordered to replenish the Treasury, Henry VII’s Lord Chancellor, John Morton, devised what is now known as Morton’s Fork when he declared: "If the subject is seen to live frugally, tell him because he is clearly a money saver of great ability, he can afford to give generously to the King. If, however, the subject lives a life of great extravagance, tell him he, too, can afford to give largely, the proof of his opulence being evident in his expenditure."  It was a perfect “Heads I win, tails you lose” argument sweeping up the miserly and the extravagant alike. 

Morton’s policy was ruthlessly carried out and was so successful that by the time Henry VIII became King in 1509, he inherited a fortune estimated to be at least £1.3 million, a colossal sum at the time and making him one of the richest kings in Europe.   However, his father’s tax policy had been highly unpopular, so one of Henry VIII’s first acts was to order the execution of two of his father’s principal tax collectors Edmund Dudley and Richard Empson, allegedly for their over-zealous use of Morton’s Fork.  A case, perhaps, of taking tax cuts a bit too literally. 

In the 21st Century we like to think tax policy is much more sophisticated and fair.  However, tax authorities, including the IRD still use Morton’s principle to assist the collection of taxes.  I recall one instance where a taxpayer pleading poverty was then asked by investigators to explain why he had been seen a week earlier driving a Rolls Royce.  A large tax bill soon arrived. 

You can't win

More commonly Morton’s Fork is applied during an IRD investigation to present taxpayers with two equally invidious positions: either accept the IRD’s position and therefore be liable for taxes, interest and penalties; or incur substantial legal and accounting costs by continuing to debate the issues (still, of course, with the attendant risk that the defence is unsuccessful).  

Given the IRD’s vastly greater resources, it is no surprise that many taxpayers concede rather than fight on even when their advisors consider they have a strong position.  Those taxpayers whose pension transfers from the U.K. were selected by the IRD for a “risk review” were facing this dilemma, so the decision to review the treatment of overseas pensions was a welcome one.

But one of the groups who are regularly confronted with the modern equivalent of Morton’s Fork would be in most people’s view the least likely to face the issue: low paid workers.   It is unquestionably good policy to get people off benefits and into employment but sometimes the interaction of tax and social welfare rules present intractable problems for the ambitious.  As a person’s earnings rise so benefits decline but not always at the same rate. 

In 2009 the Victoria University of Wellington Tax Working Group was shocked to discover that for some workers the effect of taxes and abatements of benefits/ Working for Families Tax Credits,  resulted in effective marginal tax rates of over 50% and in some instances as high as 100%.  Working more hours or even accepting a pay increase can therefore be counter-productive because of the effect on these other benefits.    

The graph below from 2007 illustrates the distortionary effects of this conundrum: instead of a relatively smooth Bell Curve note the large number of spikes at the left hand side where clearly some income manipulation is going on to avoid the effects of taxes and benefit abatements.

The final report of the Victoria University of Wellington Tax Working Group recommended a major review of the social welfare system to deal with the issue of high effective marginal tax rates. That didn’t happen but if the proposals to get beneficiaries into work are to have a long term impact then the issue of the interaction between benefits and taxation needs to be addressed.  Otherwise the low paid will continue to find themselves trapped by the 21^st century equivalent of Morton’s Fork.

*Terry Baucher is an Auckland-based tax specialist with 20 years experience.