Devil's in a lack of detail for Osborne and friends

The Lib-Con pact gives the new Chancellor carte blanche to rip up his party's manifesto – so how will he tackle the deficit now, asks Richard Northedge

On the wall of George Osborne's Westminster office is a cartoon of a former chancellor of the exchequer at his desk facing an in-tray overflowing with papers on the world recession, unemployment and the economy. The chancellor depicted is his 1970s Labour predecessor Denis Healey, but Osborne thinks he has inherited the same tray of pending problems.

He has promised a Budget within 50 days of taking office to outline his solutions. In theory his party's manifesto, produced only a month ago, tells us what to expect, but in practice the pact with the Liberal Democrats has given Osborne carte blanche to rip up his published plans. The coalition agreement negotiated by the two parties last week sets out a new set of proposals without giving details, but what it fails to mention is as important as the hints it gives.

There is no mention of the Tories' pledge of a permanent exemption from stamp duty for first-time buyers of homes costing under £250,000, for instance, or of any crackdown on non-doms.

The Liberals' proposals for limiting tax relief on pension contributions or a "mansion tax" are absent too, along with their plans for business rates and the Conservatives' promised reform of corporation tax.

But the biggest omission in the 3,000-word coalition agreement – just as it was the undebated subject of the election campaign – is VAT. Everyone from economists to retailers seems resigned to an increase but no politician will discuss it. Raising the rate from 17.5 to 20 per cent would give the Government about £10bn a year – and hit consumption by the same sum – and a 22 per cent rate would add as much again, taking VAT receipts to £100bn.

Yet useful as £10bn or £20bn would be, it makes only a minor dent in the public finance deficit – and the Con-Lib agreement to block Labour's announced national insurance increase on employers leaves another £2.5bn to find. The deficit in the year ending last month was £167bn and Alistair Darling's March Budget planned to cut that only to £163bn this year. Even by 2014-15, Darling was reducing the deficit only to £74bn with a surplus – last achieved in 2001 – nowhere in sight but public debt almost doubling over the period to £1,406bn.

And it is feasible the new Office for Budget Responsibility, headed by Sir Alan Budd, who was head of the government economic service under John Major's government, could revise those figures upward.

Osborne must take tough action to close that deficit but the Con-Lib agreement devotes more space to detailing additional expenditure and tax reductions than discussing spending cuts and revenue raising. The Lib Dems' proposal to exempt the first £10,000 of everyone's income from tax would have cost £17bn: last week's joint agreement now talks of focusing on low and middle earners, which suggests the new Chancellor may instead narrow the basic-rate tax band without helping the higher-paid.

The Tories' plan to raise inheritance tax limits are on ice while the Lib Dems remain free to oppose reliefs for married couples. But both parties' campaigns concentrated on spending cuts rather than tax rises and that remains their policy – whether the 20 per cent from tax, as the Tories wanted, or the Lib Dems' 30 per cent proposal.

The Conservatives are sticking to their controversial plan for £6bn of immediate spending cuts, even though that shrinks the deficit only modestly. The Bank of England's forecast last week of higher growth may encourage the Chancellor to conclude that the economy can absorb bigger cuts. Robert Chote, director of the independent Institute for Fiscal studies, says: "This will give the coalition parties useful cover against accusations that they are taking undue risks with the recovery".

But Osborne proposes raising health spending in line with inflation, if not at the NHS's high level of price rises, and lifting overseas aid even more while state retirement pensions will increase with the higher of earnings, prices or 2.5 per cent.

"This suggests an intense squeeze on the budgets of other Whitehall departments in the spending review due this autumn," says Chote. "It also leaves open the option of tougher action to cut social security spending and does not rule out the possibility of significant net tax increases."

Capital spending is already being halved over four years from £50bn under Darling's plan, but Osborne is limited on making cuts in the current financial year until he sees the results of the spending review. Britain is this year spending £40bn on defence – which will be separately reviewed, though the Tories have defied the Lib Dems' demand to axe Trident, £89bn on education, £122bn on health and £196bn on pensions and benefits: making cuts will be painful.

Next month's Budget can cut civil service jobs but will not follow Greece, Spain and Ireland in cutting their pay. What's more, even when the new commission on public-sector pensions reports, accrued benefits will not be reduced. And Osborne thought Denis Healey had a full in-tray?

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