By Steve Schifferes
Economics reporter, BBC News
Chancellor Alistair Darling faces the toughest challenge yet under this Labour government, as the economic and budget squeeze continue to narrow his options.
Mr. Darling is under pressure over the growing budget deficit
And he has been forced to adopt many of the Conservatives' plans for both spending and taxation after their popularity with the electorate became clear at the Conservative Party Conference.
According to Robert Chote, director of the independent Institute for Fiscal Studies (IFS), "the defining feature of Mr Darling's first big set-piece statement has been his need for extra borrowing: borrowing money and borrowing policies."
The IFS, which forecast a £10bn black hole in the government finances before the last election, says that the current financial turmoil has knocked a £6.5bn hole in the government's budget forecast, compared to the one made in March.
But it says the government is being far too optimistic about the speed at which the economy might recover - thus boosting tax revenues and closing the budget gap.
"The size of the revenue loss and the timing and speed of any recovery are clearly uncertain," Mr Chote says.
The IFS points out that so far this year government tax revenues rose much slower than the Treasury expected - but the pre-Budget Report forecasts a further rise for the rest of the year, despite the growing problems in the financial sector.
Fiddling the figures
The IFS has also warned that the government could be in danger of breaching its own self-proclaimed fiscal rules in the next five years.
Under the golden rule, the government aims not to run a deficit on current spending over the economic cycle.
NET PRE-BUDGET TAX INCREASES
Capital gains taxes: £900m
Aviation tax: £520m
Residence and non-domicile taxes: £500m
Reduced state second pension: £440m
Net tax changes by 2010/11; Source: 2007 pre-Budget report
But it is starting a new economic cycle already running a deficit, and on its own projections it will take five years before it is in overall surplus.
The IFS warns that the government might be tempted to change - for the third time - its definition of the economic cycle, extending it as far as 2008.
That would provide extra help in meeting the target - but would further undermine its economic credibility.
Tighter spending squeeze
The IFS points out that the government has extended the squeeze on public spending by two more years, to 2011/12.
The IFS says its approach is now similar to the Conservative spending principle of "sharing the proceeds of growth" by cutting the share of national income spent by government.
CHANGES TO BUDGET DEFICIT PROJECTIONS
2007 DEFICIT: -£4bn
2008 DEFICIT: -£7bn
2009 DEFICIT: -£3bn
Changes to March budget projections; source: Treasury
In the 2005 General Election Labour criticised the Conservative plans to slow the growth of public spending, saying it amounted to a £35bn cut in front-liner services.
The IFS says that on the same basis, Labour's current plans could be seen as a £9bn cut, compared to allowing public spending to rise as fast as the economy as a whole.
The squeeze also means that public sector workers will have five years of below-inflation pay rises, stoking possible industrial action.
And in another sensitive area, council taxes are likely to rise as the government has only allowed 0.8% growth in its grants to local authorities.
Growing tax burden
The IFS says that taxes are also rising in order to close the budget gap.
It says that over the whole period of a Labour government, up to 2010/11, taxes will have gone up by £43.5bn.
Two thirds of that increase will have come in announced tax rises - but the rest will derive from fiscal drag, where individuals are pulled into higher tax bands as their income rises but tax thresholds fail to keep pace.
That means that of the average increase in real household income over these 16 years of £12,000, about £5,400 has been collected in taxes, and £6,600 has been retained by individuals to spend on what they like.
In the next five years, personal income is projected to rise by an additional £5,500 per family, and the government will be collecting £2,600 of that.
The end of redistribution
Another new feature of this budget is that, for the first time, Labour is giving more back to the rich than the poor.
The changes to inheritance tax, raising the threshold to £600,000 for married couples, will cost about £1.4bn, and mainly benefit better-off families in the South-East.
Meanwhile, the changes to the tax credit system, designed to help mainly low-income lone parent families, will cost around £580m, and will take about 100,000 children out of poverty.
The IFS says that the government is very far from its aim of halving child poverty by 2010, and has previously estimated that it would cost £3.8bn to take the 800,000 children out of poverty that would be needed to meet that target.
The distributional effect of other tax changes - such as airline taxes, non-domicile taxes, and capital gains taxes - is uncertain, as they may hit some groups of the rich more than others.
But overall, the net effect of the new tax changes is to raise £3bn, more than offsetting the cost of the inheritance tax changes.
And if the world financial turmoil gets worse, and hits the real economy harder, the pressure on the budget - and the need to find more cuts, and more taxes - will only intensify.