Economists warn of Budget tax rise risks: Sharp increases would push underlying rate of inflation well above 4% target ceiling, Clarke told

SIGNIFICANT tax increases in next month's Budget would slow economic growth and push the underlying rate of inflation sharply above the Chancellor's 4 per cent target ceiling, according to the computer model of the economy used by the Treasury to estimate the effects of different policies.

Independent economists using the Treasury model believe the economy will grow by 1.7 per cent this year, rising to 2.6 per cent next year and slowing thereafter, assuming taxes are raised - or spending cut - by pounds 3.5bn in the Budget.

Taking an extra pounds 1bn in November and a further pounds 7bn next year would significantly slow the recovery from 1995 onwards and limit any falls in unemployment. Underlying inflation would rise to more than 5 per cent by the end of 1995, necessitating higher interest rates to control price increases.

Brian Pearce, chief economist of the Ernst & Young Item Club, said the study showed that the economic picture was 'generally bright but fragile'. It was possible that the economy could enjoy a low inflation recovery with costs under control, but 'the balance of risks . . . all suggest the Chancellor should raise taxes with caution'.

Meanwhile, a new survey of company executives from Dun & Bradstreet, the business information service, shows economic recovery flattening out and demand for Britain's exports at its most feeble for a year. Confidence in sales has risen for the fourth successive quarter, but companies are less optimistic about profits and expect new orders to stagnate.

Nationally, optimism about sales is at its highest for four years, but companies are also more confident that they will be able to raise prices than at any time since the autumn of 1991.

The warnings come as Treasury ministers and officials prepare to meet on Friday at the Chancellor's country residence of Dorneywood to decide the shape of the Budget.

Kenneth Clarke is thought to be leaning towards a modest rise in taxes for the coming fiscal year, phasing in more significant increases in later years to allow recovery to take root.

The Treasury believes that a subsequent improvement in next year's economic outlook may well produce a more optimistic projection of Britain's borrowing needs over the next few years.

Among Mr Clarke's options for higher taxes are:

Outright abolition or cuts in mortgage tax relief. From next April relief will be restricted to 20 per cent from the current 25 per cent. The rate could be cut further or the amount on which relief is avaliable reduced from pounds 30,000.

Restricting personal allowances to the basic or 20p income tax rates, reducing their value to higher earners. The last Budget froze income tax allowances.

Extending the VAT base. This includes newspapers, magazines and books, which at the standard rate of 17.5 per cent would raise pounds 1.1bn. Other options include children's clothes (raising pounds 600m) and international transport ( pounds 1bn).

In the run-up to the Budget on 30 November, Treasury economists think their final predictions for the public sector borrowing requirement are likely to show a sizeable improvement from 1994/5 onwards over projections made last March. The outturn for the current fiscal year, however, may be only a few billion pounds less than the pounds 50bn forecast in the last Budget.

Treasury officials have still to conclude that additional tax increases in 1994/5 - on top of the pounds 6.725bn already announced - are absolutely necessary. But increases in later years are being considered. Speculation about a pounds 4bn- pounds 6bn package of tax increases may still prove correct, but they are likely to be spread over several years.

Crucial to the Chancellor's decisions will be the September retail price index, due on Wednesday. The August figures revealed an unexpected increase in the headline rate to 1.7 per cent and to 3.1 per cent in the underlying rate.

Financial markets are worried that Wednesday's figures might be worse, ruling out altogether hopes of a winter cut in base rates.