Chancellor sharpens his knives: Robert Chote says likely options include making firms pay the bill for sick pay and injury schemes

DESPITE the risk of pre-Christmas portrayal as Ebenezer Scrooge, Kenneth Clarke will take the knife to Britain's pounds 80bn social security system in the Budget a week today.

A series of leaks have made it clear that Mr Clarke intends to bring in significant changes to the benefits system: stricter targeting, the shifting of costs to employers and incentives for individuals to opt out of state entitlements.

Tough decisions on social security are needed merely to offset increasing pressure on its budget. This will be crucial if Mr Clarke is to cut total public spending below the targets set by the Cabinet in July, thus mollifying the financial markets and the Conservative right. Michael Portillo's review of social security spending appears to have borne fruit already, some of which will be harvested next week.

The Department of Social Security has already prepared the ground for cuts, warning in July that benefit spending was set to rise by at least 3.3 per cent a year until the end of the decade, taking the benefits bill to almost pounds 100bn a year.

But this softening-up exercise has come in for criticism following the publication of The Future of Welfare, a study by economists at the London School of Economics for the Joseph Rowntree Foundation. The Opposition cited the report's conclusion that 'there is no demographic time bomb which will cause an unsustainable explosion of welfare costs' as evidence that the Government was scaremongering.

But the Rowntree report also concludes that maintaining or improving welfare state provision in relation to need and living standards will demand 'a slow rise in the share of welfare spending in gross domestic product and hence in the taxes or contributions required to pay for it'. This is not a price the Government is willing to pay.

One solution the Government seems to favour is shifting some benefit costs to business. Firms could be handed the pounds 1.4bn bill for the cost of statutory sick pay and industrial injuries schemes. Around 330,000 people are normally claiming sick pay at any one time, receiving around pounds 50 a week. This costs pounds 700m, with a similar sum spent on industrial injuries benefits.

Business would have to be given some tax concession to help offset the costs. This would probably come in the form of a cut in the rate of contributions employers make towards their workers' National Insurance payments. The Government could argue that a cut in this 'payroll tax' might create jobs by making it worthwhile for firms to take on more people.

A much hotter political potato is the prospect for Britain's 1.3 million lone parents. The Government has been considering cuts in one-parent benefit and lone-parent premium, restricting benefits for those who have children while on income support and encouraging lone parents to live with their parents.

Invalidity benefit is another area in which greater targeting is likely because it takes no account of the income of the recipient. The bill has grown sharply and is expected to continue doing so, in part as older long-term unemployed move on to the benefit. The number of recipients has more than doubled since the early 1980s, and the bill is expected to rise by pounds 600m next year to more than pounds 7bn. The cost of the benefit could be cut by taxation, restricting it to people below pensionable age or partially withdrawing it from people with private pension incomes.

Greater targeting of unemployment benefit is also tempting. The Chancellor is considering cutting the period for which benefit can be received from a year to six months. The unemployed would then have to move to income support, which is just as generous but is also means- tested. This would hit the unemployed wives of working men and would raise around pounds 200m.

The Government will probably argue that cutting the income of unemployed people makes it more attractive for them to find work and thus helps to cut unemployment. But a study by economists at Warwick University in the October Journal of Applied Econometrics found that the amount of income people receive while unemployed makes no difference to the likelihood of them finding a job once they have been unemployed for five months or more.

Reforms for Recovery, a recent study by the accountants Ernst & Young, suggests that invalidity and unemployment benefits are also candidates for a transferral of costs to companies. It says: 'Employers could be required to pay, say, the equivalent of the first three or six months' unemployment benefit entitlement or, where sick leave is work-related, the first few months' invalidity benefit. Employers could be given a lower rate of National Insurance contribution in return for taking over these payments and in turn could, if they chose, take out insurance to cover their risks.'

Housing benefit might also be targeted more strictly, cutting its value to people with incomes above the income support level. But this would make it less worthwhile for people with high rents to work.

The largest part of the social security bill is the pounds 30bn spent on the state retirement pension. The scope to make immediate revenue gains from changes here is limited, but the Budget could be used to introduce longer-term changes which might be beneficial to public finances in future.

One unresolved issue is the age at which people become entitled to pensions, currently 65 for men and 60 for women. The options include equalisation of entitlement ages at 60, 63 or 65, or a so-called 'flexible decade of retirement'. Raising women's entitlement age to 65 would raise around pounds 3bn a year, the Institute for Fiscal Studies says.

More fundamantally, the Government may offer incentives for people to opt out of the state pension scheme altogether in the same way that many people now opt out of the state earnings-related pension scheme (Serps).

The Ernst & Young report also argues that the arrangements for contracting out of Serps could be changed. People may no longer be required to contract out into schemes providing benefits at least as great as those provided by the state scheme, but merely into schemes providing 'reasonable benefits'. Further accrual of Serps could even be cancelled and the basic state pension built up instead. This would be consistent with later abolition of the upper limit of National Insurance contributions as Serps is only based on incomes up to that limit.

There are no easy answers to the dilemmas posed by the pensions system. As the IFS's Green Budget notes: 'On present policies the basic state pension will simply wither and die by the time today's school-leavers reach retirement age. On the other hand, the state cannot provide a worthwhile flat-rate pension for 15 million pensioners without major tax increases.'

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