By Steve Schifferes
BBC News Online economics reporter
The rising UK budget deficit may force the government to raise taxes or slow the rise in public spending.
Gordon Brown: Will he break his own fiscal rule?
The warning comes from the influential Organisation for Economic Cooperation and Development (OECD), the think tank for the world's richest countries.
The OECD says that its projections suggest "the need for further fiscal action" to avoid "diminishing the credibility of the fiscal framework".
The chancellor hopes faster economic growth will reduce the deficit.
But the OECD says that the UK budget deficit will exceed the limit set by countries in the eurozone of 3% of GDP by 2005.
And it warns that "the jury is still out on whether the massive spending
increases will fully pay off in terms of improved service."
The OECD report does contain good news for Gordon Brown on economic growth.
It says that the "UK economy has proved remarkably resilient during the current downswing" and "seems well-placed to take advantage of the global recovery and move towards a more broadly based growth that relies less on consumption and housing wealth".
UK Budget Deficit
2002: 1.53% of GDP
2003: 2.91% of GDP
2004: 2.94% of GDP
2005: 3.23% of GDP
But it warns that the "propensity of housing prices to surge... may be a source of fragility in the context of inelastic housing supply and rapid build-up of housing debt".
It urges the Bank of England to gradually raise interest rates to avoid the risk of "more abrupt tightening later on" which could damage the economy.
Public sector reform needed
The OECD strongly endorses the government's proposals for public sector reforms, including the introduction of higher tuition fees funded by repayments from graduates.
It says that "expanding higher education based on contributions from those who benefit from it rather than based on general tax revenues is the most direct way to ensure equity in education outcomes".
And the report argues that putting more public money into early education is the best way to increase equality by helping overcome the early disadvantage faced by students from poor backgrounds.
The OECD also endorses the introduction of other user fees, such as charges for missed hospital appointments or for extra non-generic drugs, "to improve incentives while raising some revenues".
And it says that the government faces a long-term strategic choice in either accepting higher taxes and mandatory contributions or "expanding private funding in ways that do not compromise equity concerns".
Higher rates are needed to stop a house price crash, OECD warns
It also says that a slowdown in the rate of expansion of government funding for the public sector might help improve productivity, especially in health care.
It warns that without productivity improvements much of the extra money spent on health and education may be wasted.
"Avoiding locking in inefficiencies as a result of too-fast spending growth is therefore also crucial in a longer term fiscal perspective."
Conservative Shadow Chancellor Oliver Letwin criticised the government's record on public services.
"With experts warning that the Government must tighten its belt, people will want to know why the extra taxes they're already paying haven't delivered anything like the improvements in public services they were promised," he said.
Liberal Democrat Treasury spokesman Vince Cable said that Gordon Brown's "strategy now is to cross his fingers and hope he can postpone tax increases until after the next election."
But the Chancellor, Gordon Brown, said:
"What we have got is another report today that says that we are doing the right thing in
equipping Britain for the future."