Osborne's Bombshell: Chancellor declares war on middle-class welfare

Big cuts in the £170bn-a-year social security budget will be sought by the Government as it launches a fundamental review of all public spending to reduce Britain's £156bn deficit.

Universal handouts such as child benefit could be means-tested for the first time and halted for the middle classes and the rich. The review is expected to consider the level and scope of benefits for the jobless, sick and disabled – including the option of freezing them temporarily.

Such moves would be highly controversial and would call into question the Liberal-Conservative coalition's promises to protect the poor and most vulnerable in society, and could anger many people who voted Liberal Democrat in last month's election.

Ministers hinted that pensioners would keep their winter fuel payments, free bus passes and TV licences. But, in another blow to middle-income families, Gordon Brown's £23.6bn flagship tax credits scheme will be pared back.

Benefits, tax credits and the generous pensions paid to public service workers were the three areas targeted for cuts in a Treasury document published yesterday giving the first clues as to where the axe could fall. George Osborne, the Chancellor, warned the Cabinet yesterday that departments other than health and international development whose budgets are not ring-fenced could be reduced by up to 20 per cent.

To give cabinet ministers an incentive to provide "more for less", he said those who settled their budgets quickly with a new "star chamber" of senior ministers could join the group and sit in judgement on colleagues who were dragging their feet.

Mr Osborne will chair the star chamber. Its deputy will be Danny Alexander, the Liberal Democrat Chief Treasury Secretary. Other members will include the Foreign Secretary William Hague and the Cabinet Office ministers Francis Maude and Oliver Letwin. The group will end Labour's policy of treating social security payments as "demand-led". It will look at issues that affect several departments such as public-sector pay, local government and strategic decisions such as reform of the welfare state.

Mr Osborne, who refused to rule out means-testing child benefit, said: "This is the great national challenge of our generation: after years of waste, debt and irresponsibility, to get Britain to live within its means.

"We didn't choose the terrible economic situation we inherited. But we can work to put it right, to set our country on a brighter economic course, and show that we are all in this together."

The Chancellor was silent on tax rises yesterday but intends that they will meet about 20 per cent of his deficit reduction plan, with 80 per cent coming from spending cuts.

Some tax increases and the size of the public spending cake for the next four years will be announced in the Budget on 22 June. The public will be consulted before ministers decide how the cake should be shared out in the autumn.

Mr Osborne said: "We are genuinely seeking to engage as many people as possible, the brightest civil servants, the best people from the devolved administrations, the best people from pressure groups, think tanks and the frontline public services."

But the SDLP's Mark Durkan mocked the Government's efforts to "popularise" its cuts agenda, asking: "How is this 'axe-factor' approach to government going to play out?"

Frank Dobson, a former Labour health secretary, claimed the coalition was "positively drooling at the prospect of slashing public services".

In the line of fire

Social security benefits: £170bn

By far the largest area of government spending, and forecast to go above £200bn in 2010. Around £85bn goes to those out of work, although some of that includes tax credits. Around 3.2 million working-age households claim housing benefits. Almost 2.5 million people have claimed income support or incapacity benefits for more than two years.

Tax credits: £23.6bn

It is thought the amount lost in the tax system amounts to £1.7bn. Child tax credits or working tax credits can be claimed by people employed or self-employed and work at least 16 hours a week. A £4-a-week rise was due to come into effect in 2012.

Public-sector pensions: £4.4bn

Regarded as a time bomb. The National Audit Office has revealed that unfunded public-sector schemes would be paying out £79bn by 2060, compared with £25bn in 2010. The huge rise comes as a result of the real earnings of public-sector workers, who are also living longer.