By Steve Schifferes
BBC News Online economics reporter
The chancellor will have to raise taxes by £10bn to meet his fiscal targets, a leading think-tank has predicted.
Mr Brown keeps smiling despite a record UK deficit
The Institute for Fiscal Studies says that Mr Brown would need to raise taxes by 2006 to prevent the budget deficit spiralling out of control.
It warns that the budget deficit will still be £38bn in 2006, £11bn more than the Treasury has predicted.
Under the government's "golden rule", borrowing and current spending must balance out over the economic cycle.
Debt forecasts up
Recently, Gordon Brown was forced to raise his public sector deficit forecast for this fiscal year to £37bn, up from the £27bn figure predicted in his Budget speech in April.
But the deficit could be even larger, as last month the public sector net cash requirement (PSNCR) rocketed to £13bn, a new record, leading to a total public debt of £36.1bn so far.
The IFS says that the government will just achieve its target of meeting the golden rule over the current economic cycle which is expected to end in 2005-6, but with no margin to spare.
But it warns that it will be in danger of breaching its own rules in the future.
The IFS warns that, contrary to government forecasts, it will begin the next economic cycle with a deficit of 0.8% of GDP, and "to safeguard the golden rule in the future would require that this gap be closed" by a tax increase of £10bn.
It added that, in order to give a margin of error, Mr Brown should aim slightly higher, running a small surplus in 2006-7 by raising between £13bn-17bn in new taxes.
IFS director Robert Chote told the BBC that, although the chancellor could delay a decision to raise taxes until after the expected date of the next general election, he risked undermining his reputation for fiscal prudence, and reducing his credibility with financial markets.
The chancellor has been forced to borrow more money to back Labour's pledge to pour billions of pounds into ailing public services, particularly schools and hospitals.
The IFS suggests that in order to meet his targets, the government will have to limit the rise in public spending as a percentage of national income.
It says there will be "pressures facing many government departments to deliver noticeable improvements in public services without further increases in their resources".
FORECAST BUDGET DEFICITS
2003-4: £37.4bn (£36.7bn)
2004-5: £31bn (£34.7bn)
2005-6: £29.9bn (£37.9bn)
2006-7: £27bn (£38bn)
2007-8: £38bn (£27bn)
Source: HM Treasury, IFS
(IFS forecast in brackets)
The government will announce its spending plans for the next three years in July, and already there is reported to be tough in-fighting between the Treasury and the spending departments.
The squeeze is particularly acute because the government has already pledged to keep health spending rising by 7% per year until 2008.
If the government were to meet the budget gap by cutting spending rather than raising taxes, it would need to reduce the growth of public spending by 1% over the three years 2005-2008.
For the Conservatives, Shadow Chancellor Oliver Letwin said:
"People will be alarmed to hear claims that the Chancellor would need to raise taxes ... when they see that the extra taxes they've already paid haven't delivered anything like the improvements in public services that everyone wants to see."
The IFS argues that the Treasury is being over-optimistic in predicting that tax revenues will rise as a percentage of national income over the next few years without additional tax measures being needed.
It suggests that the most likely source of new tax revenues might be to freeze the income tax personal allowances, or to raise more from national insurance.
POSSIBLE TAX INCREASES
Freeze personal allowances: £8.8bn
Abolish upper earnings limit on NI: £7.5bn
Align NI and higher rate tax: £1bn - £3bn
Freezing personal allowances could raise £8.8bn by 2009-10, but would result in an additional 2.4 million higher rate taxpayers and would broadly hit taxpayers all across the income spectrum.
Abolishing the upper earnings limit on national insurance would raise £7.5bn, while affecting mainly higher income taxpayers.
Other adjustments to national insurance could raise several billion pounds, for example by aligning the higher rate tax band and the upper earnings limit on national insurance.
The chancellor is already relying on "fiscal drag", the fact that every year more people are pulled into higher rate tax bands, to raise a substantial proportion of the new tax revenue needed.
But any such moves could add fuel to a expected Conservative campaign in the next general election against increased taxes for the middle class.