The Bank suggests the Chancellor should raise up to half the money in next month's Budget. It does not specify particular measures, but this could represent a tax rise this year equivalent to 1.5 percentage points on VAT, taking the rate to 19 per cent.
The Chancellor may prefer to broaden the base of VAT, bringing products such as newspapers into the net. An equivalent rise in income tax would add 2p to the basic rate. In future years, some reduction in borrowing could come from public spending cuts.
The Bank's approach goes against some senior Bank voices who want even stronger measures to deal with the budget deficit - the excess of public spending over revenues - which is expected to reach pounds 50bn this year. Tougher action would be offset by a sharper cut in interest rates to keep the recovery going.
However, the Bank's confidential paper, prepared for a meeting of Treasury ministers at the Chancellor's country house at Dorneywood on Friday, is thought to be broadly in line with Kenneth Clarke's instincts about what may be politically acceptable. Eddie George, the Governor, is said to have struck up a warm relationship with the Chancellor.
Professor Mervyn King, the Bank's chief economist, is also thought to be against a larger tax increase on the grounds that the recovery has been weakened by the hangover of debt from the free-spending Eighties.
In a recent lecture, Professor King pointed out that consumer and other spending has been much more subdued over the past year than in a normal recovery, especially given the scale of interest rate cuts.
Professor King's views on the depressive influence of debt have been reinforced by a sharp revision downwards of manufacturing output estimates and by uncertainties surrounding Britain's trading performance in the face of continental recession.
The Chancellor was also urged by members of the 'seven wise men' who provide him with independent economic advice to accompany any tax increases on 30 November with a cut in interest rates. Six of the seven - Cambridge professor Wynne Godley was in America - met at the Treasury yesterday to meet the Chancellor and prepare their pre-Budget report, to be published next week.
Gavyn Davies, chief economist at Goldman Sachs and economics columnist of the Independent, said: 'There is a feeling among some of us that we should cut interest rates if the Chancellor is going to increase taxes further.'
Mr Davies said the Chancellor appeared to be thinking of bringing forward the 1995 increase in VAT on fuel to next year and then increasing taxes further. 'If this is done, it is quite a big budgetary hit to the economy. I am not convinced that the recovery is sufficiently robust to take that with interest rates remaining unchanged.'
Despite some City optimism that the outlook for the public finances may have improved since the March Budget, the Bank's forecast is thought to have changed little.
The Bank's argument in favour of tax increases or spending cuts worth some 1 per cent of national income, phased in over a period, is based on the view that the Government will otherwise face a large budget deficit even when the recovery boosts tax revenues.
The forecast at the time of the last Budget suggested that the deficit would still be 3.75 per cent of national income even in 1997-98, when the economy should be growing normally. That is too high to stop the national debt rising as a share of national income.
The Bank would like the Government to ensure that the debt-to-income share shrinks in good times, to allow room for it to rise in bad ones.
The Treasury's latest monthly report on the economy said recent indicators suggested that recovery remained intact and that the financial markets were increasingly expecting low inflation to be sustained.
The Dorneywood meeting is expected to last all day and will be attended by all the Treasury ministers, their special advisers, and the four permanent secretaries, Sir Terence Burns, Professor Alan Budd, Andrew Turnbull and Sir Nigel Wickes.
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