No easy tax targets as Brown seeks to balance the Budget

With 14 days to go until the Budget but 14 months until a likely general election, Gordon Brown faces one the toughest challenges of his political career.

He is raising less in tax revenue than he hoped for and is spending more than he budgeted for. For Charles Dickens' Mr Micawber the result is misery but for the economists, the outcome is a more dramatic "black hole" that will eventually require tax rises or spending cuts.

The Chancellor is unlikely to countenance any unpopular - or manifesto-breaking - tax rises so close to polling day. Instead Tony Blair will look to his Chancellor to deliver a tax-cutting gesture in Budget 2005 to boost voter support in advance of the election.

According to PricewaterhouseCoopers, the accountants, Mr Brown will have to find between £10bn and £15bn a year in extra taxes or lower spending to balance the books - equivalent to 3p to 5p on income tax.

This is based on the fiscal rules that the Chancellor set for himself. The most important is that over the economic cycle, the Government must ensure that it does not borrow to fund current - non-investment - spending.

Most analysts believe Mr Brown will squeak inside the rule narrowly in the current cycle, which will probably end next year, but will start the next one deeply in the red.

"There is no immediate crisis in the public finances that requires remedial action in the 2004 Budget," said John Hawksworth, PwC's head of macroeconomics. "But eventually the Chancellor is likely to either increase taxes or tighten spending more sharply than indicated in [December's] pre-Budget report."

Spending has already jumped high up the political agenda with both the Tories and Lib Dems identifying billions of pounds of Whitehall waste to cut.

The Government has found its own "waste windfall" in the form of £15bn of savings within public services expected to be identified by Sir Peter Gershon, the head of the Government's efficiency review, on Budget day.

But if the Chancellor wants to take early action to balance the books, he must impose tax rises. This is where it gets interesting.

The frantic speculation over recent weeks has made some of the City's austere accountants resemble their turf colleagues in setting odds on possible gambits. John Whiting, Mr Hawksworth's tax colleague at PwC, would offer odds of only 8-1 that the Chancellor would try to raise the full £15bn on 17 March.

Some of the "runners and riders" are ruled out by the manifesto. The Government has pledged not to raise the basic or higher rates of income tax.

"We have kept all our manifesto promises on tax and we will continue to keep all our manifesto promises on tax," Mr Brown told MPs yesterday.

The other tempting cash cow, which Mr Brown has already raided, is national insurance. Freezing the income tax and NI thresholds would raise £8.8bn, according to the Institute for Fiscal Studies. It added that raising the contribution rate on earnings above the upper earnings limit from 1 to 6 per cent would raise £4bn.

However, as one economist put it: "The Government raised national insurance in exchange for improving the NHS. To do it again because he had simply run out of cash would be seen as highly cynical."

The other area for fevered speculation is the housing market. House prices have started to accelerate again in the new year, raising renewed fears of a property crash and allowing the Chancellor to portray himself as acting in the public interest by acting to slow it down.

"The Government may launch a fresh set of attacks on the householder and people looking to buy and develop second homes," said Steve Durman, at accountants Moore Stephens. "Justified by spiralling house prices in the South-east, the Government may allow main residence tax-breaks only on properties owned for more than two years."

Significantly, the Treasury will publish the results on the independent inquiry it commissioned into the housebuilding industry on or near Budget day.

Analysts point out that just before Mr Brown unveiled his NI increase, he published a report carried out by Sir Derek Wanless, concluding that the NHS should be funded from direct taxation. Kate Barker highlighted distortions around the stamp duty thresholds and lent her support to government plans for tax-transparent property investment vehicles.

Anne Redston, a tax partner at Ernst & Young, said he could raise the stamp duty rates by another percentage point. "The simple fact is that it is an easy way for him to raise money," she said. "The collection mechanism is there and people who would have voted Labour are not going to vote Tory because of higher tax on a one-off transaction."

But the really tempting option is to raise VAT, the tax paid automatically by shoppers every time they make a purchase. Currently set at 17.5 per cent, it was last hiked in 1993 to pay for the abolition of the poll tax, and now raises £69bn a year. Lifting it to 18.5 per cent would net £4bn, according to the IFS.

One drawback is that VAT is seen as a regressive tax - costing the poor proportionately more than the rich - and would appear to counter Labour's tradition of redistributing wealth.

Ms Redston said that, like stamp duty, it would be easy to implement and collect. She said preserving zero-rating on basic items such as food and clothes could help Mr Brown "concoct a defence".

"To some extent it is a tax on choice," she said. "If people choose to buy other goods or services or be entertained, that's not quite the same as putting up tax on food and necessities." An even stealthier money-raiser would be to freeze the threshold on higher-rate tax. More than one in 10 people pay income tax at 40 per cent compared with one in 40 in 1978. Freezing it would see more people pay more tax.

Beneath these "big-hitting" taxes there is a myriad of different levers the Chancellor can pull. He is likely to freeze duty on spirits for the seventh year in a row but punish smokers and drinkers of wine and beer.

He will detail plans to close a tax loophole that allows thousands of wealthy non-domiciled UK residents, which could raise up to £1bn a year.

Mr Brown has made clear he will close a loophole he created by zero-rating small businesses for corporation tax, encouraging thousands of sole traders to set up companies. He has lost £1bn and is likely to impose a tax on dividends that will make up the loss and raise an extra £1bn, Ernst & Young believe.

The Chancellor has already announced plans to close a loophole exploited by investors in film productions and a crackdown on VAT avoidance to raise £450m.

Could there be tax cuts? Mr Brown has already pre-announced measures for small business. This week he pledged to increase spending on science.

But he will keep his tax-cut powder dry for Budget 2005, leaving the real focus on his need to raise money? Ms Redston said it was an "evens bet" whether the Chancellor would use Budget 2004 to impose a significant tax rise.

"I think it will really come down to his level of confidence in his forecasts," she said. "If income and expenditure diverge and there's a really big gap, he would have to something unpopular in 2005 like raise VAT.

"Otherwise he has to hold his breath now, dive into the water and hope he keeps holding it until the other side of the election, when I am sure the first thing he will do will be to raise national insurance again."