IFS warns of Brown's £5bn black hole

Think tank hints that Chancellor may have to raise VAT to pay for higher spending on health and education

Is Gordon Brown planning to become the new Norman Lamont? A jarring visual image maybe, but it is one of the conclusions of a forecast of what might be in this year's Budget.

Eleven years ago the then Tory Chancellor raised the rate of VAT by 2.5 percentage points to 17.5 per cent to pay for the abolition of the hated poll tax.

Now the Institute for Fiscal Studies, a highly respected independent think tank, believes VAT may have to be hiked again, this time to ensure the Government can pay for its plans for huge public expenditure on health and education.

The IFS believes Mr Brown faces a "black hole" of as much as £7bn as the Treasury compiles its Budget, due to be published on 17 April, and its Comprehensive Spending Review in July. The CSR will outline what Whitehall will be given for the two financial years between April 2004 and April 2006.

Mr Brown has tended in previous years to end each financial year with a surplus on current spending equivalent to around 0.7 per cent of GDP. But the IFS forecasts showed that with economic growth slowing and government spending accelerating to meet targets for health and education, that surplus will be close to zero between 2002 and 2006.

This would still allow the Chancellor to meet his "golden rule", that the budget must be at or close to surplus over the economic cycle. To make up that gap – which the IFS described as the "caution cushion" – would cost £5bn of either tax rises or cuts in non-core areas of spending. If the Government wanted to go further and raise the share of national income in his July CSR, that would involve further tax rises.

If it raised it from 2.5 to 2.75 per cent that would cost £1bn while, if its decided on a step-change to 3.0 per cent, that would be £2bn a year and so on.

This might well be needed to meet Labour's pledge to get health spending, currently languishing at the bottom of a European league table, back to the average of the EU.

Andrew Dilnot, the IFS's director, said the Chancellor could probably get away without the £5bn tax hike unless he wanted to be "mind-numbingly cautious". "We would quite openly say that, of that £7bn, the £5bn could quite legitimately not be done," he said. "If they sought just to meet the 'golden rule' it would be hard to criticise them."

The danger would then be that the Chancellor would leave little room for unexpected spending commitments – foot-and-mouth, 11 September and the Afghan war come to mind – that could then push the budget into deficit and break the golden rule.

The next step therefore – and this is where we come back to Lord Lamont – is to work out where any extra tax revenue could come from.

One problem the Chancellor faces is that he has already closed almost all the existing tax loopholes. Tom Clark, an IFS economist, said: "He is running out of fringes to trim."

Until the mid-1970s, the first seam to be mined by tax-hungry Chancellors was income tax rates. These have fallen over the past quarter of a century and a rise would be politically unpalatable. More importantly, New Labour pledged before last year's General Election not to increase the basic or top rates of tax. This left two areas where the Government could hope to raise taxes – VAT and National Insurance. The Government has already ruled out extending VAT to exempt items such as newspapers and public transport. But hiking VAT by another 2.5 per cent to 20 per cent would raise £9bn a year.

Mr Clarke said the main problem for Labour was that an increase in VAT would be "slightly regressive" – the poorest in society would lose a greater share of their weekly income than the richest. "Implementing this in isolation would represent something of a break with the redistributive direction of reforms introduced in Labour's first term of office," he said.

The Chancellor has specifically refused to be drawn into a pledge on National Insurance. This would allow him to either raise the rate, or to abolish the upper earnings limit.

A 1 per cent hike would raise £7.2bn if extended to the self-employed and to unearned income excluding pensioners.

Abolishing the upper limit would raise £5.9bn and have the added advantage of only affecting those who already pay the top 40 per cent rate of tax. This is the most popular current theory and with a Budget and a CSR this year the Treasury knows it is open season for tax speculation. But yesterday it was playing a straight bat. A spokesman said any decisions on spending after 2003-04 were for the CSR. "The Government remains on track to meet its tough fiscal rules," he said.

Economists believe the Chancellor is still more likely to beat his own fiscal forecasts. David Hillier, chief UK economist at Barclays Capital, said the Treasury had already factored in some overly harsh assumptions on falling share prices, City bonuses and company profits. "The Government won't want to be raising taxes in the back half of this Parliament," he said. He expected the CSR to deliver real terms spending increases of 1 per cent rather than 3 or 4 per cent in the previous one. "That's how any shortfall will be made up," he added.

The one exception might be health spending, which the Government has hinted strongly may be paid for by a ring-fenced tax. A report by Derek Wanless will be published this spring. "We will probably get away with a ring-fenced tax increase with the Government saying 'blame it on Wanless'," Mr Hillier said.