Plans have been drawn up to withdraw thousands of UK and US troops from Iraq by the spring of 2006.
The UK has more than 8,000 troops in Iraq
The paper, by Defence Secretary John Reid, suggests the UK's 8,500 troops in Iraq could be cut to 3,000, saving around £500m a year.
The document, leaked to the Mail on Sunday, also sets out US plans to cut its troops from 176,000 to 66,000.
However, Mr Reid said this was only one possibility and troops would stay in Iraq "as long as they were needed".
He said in a statement that "no decision" had been taken over the future deployment of troops.
The document, called Options for Future UK Force Posture in Iraq, was marked Secret: UK Eyes Only.
In it, Mr Reid, who confirmed he drew up the plan, said later this year Britain would need to reach decisions on troop levels for next year.
The UK's troops in Iraq are currently deployed in four southern provinces.
In the document, Mr Reid said Britain wanted to hand over to Iraqi control the Al Muthanna and Maysan provinces in October 2005, and the other two provinces, Dhi Qar and Basra, next April.
"This should lead to a reduction in the total level of UK commitment in Iraq to around 3,000 personnel, ie small scale," the document said.
Mr Reid's also wrote of a "strong US military desire" for "significant" troop reduction.
He suggested the US wanted to hand over control to Iraqi forces in 14 out of 18 provinces by early 2006.
But the document also said the Pentagon and US commanders in Iraq were divided over the plans.
Mr Reid's statement insisted no decisions had been made.
"We have always said that it is our intention to hand over the lead in fighting terrorists to Iraqi security forces as their capability increases," he said.
"This is but one of a number of such papers produced over recent months covering various scenarios. This is prudent planning. "
BBC political correspondent James Hardy did not believe this document represented a change in policy over Iraq.
"Tony Blair has repeatedly insisted that British forces will stay in Iraq for as long as they're needed.
"That policy hasn't changed, but it's clear detailed planning is under way for at least a partial withdrawal."