The Treasury is poised to downgrade its forecast for growth in 1996 and admit that government borrowing will be billions of pounds higher than its original target. A shortfall in tax revenues last year has derailed the original borrowing plans.
As a result of the disappointing state of the government's finances, the Chancellor is expected to play down hopes of any tax cuts this year when he publishes the department's summer forecast on Tuesday.
His problem will be how to present the forecast without diluting his upbeat message that the economy will recover by next spring. The Chancellor recently signalled that he would prefer the latest possible election date to take advantage of the recovery in growth which is being fuelled by a strong upturn in consumer spending.
The growth forecast for this year will be cut to 2.5 per cent from 3 per cent, as the Chancellor hinted in last month's Mansion House speech. The promise of 3 per cent growth will be postponed to 1997.
The Treasury's projection for the public sector borrowing requirement will be raised from pounds 22.4bn to around pounds 27bn.
The new Treasury outlook will be released days before ministers and officials meet at Chevening, the foreign secretary's Kent residence, for the first discussion of this year's Budget strategy.
The rickety state of the Government's finances leave Mr Clarke little scope to put more money into voters' pockets, and holds out the prospect of an even tougher spending round with government departments than usual.
Without reductions in planned public expenditure it will be impossible to justify lower taxes, but there are clear signs from areas such as health that the current targets will prove extremely difficult to achieve. The Cabinet is due to discuss expenditure plans within the next fortnight.
Spending has been right on target for the past two financial years. But many economists think the current year's tough target of 1.2 per cent growth will be too difficult to meet.
Steven Bell, chief economist at investment bank Deutsche Morgan Grenfell, said: "It is the normal pattern to play down tax hopes at this time of year." However, the disappointing outlook for the PSBR meant the room for reductions was genuinely limited, he added.
Most City economists still expect Mr Clarke to deliver lower income taxes in the Budget. Bill Martin, chief economist at Swiss bank UBS, said: "He might unveil more public expenditure savings when we get to the Budget. Another pounds 3bn off an already implausible set of plans is neither here nor there."
Mr Martin predicted the incoming government would inherit a large deficit after the election.
The Treasury forecast next week will assume that current spending targets, which were cut by pounds 3.2bn in last November's Budget, are met. However, departmental spending in the first two months of this financial year has run well ahead of the plans, and many observers think the overrun will continue.
In addition, compensation for BSE will eat up much of the contingency reserve for emergency overspending, one of the traditional sources of funds for tax cuts. The cost of the mad cow crisis is currently put at about pounds 2bn over three years.
The net pounds 3.1bn tax cuts announced last Budget, which came into effect in April, were financed from the contingency reserve, tougher plans for spending and the assumption of higher privatisation revenues.
Tax revenues as a whole have now stopped falling behind the Treasury's forecast, although income tax receipts were down 5 per cent in the year to May. But the legacy of last year's pounds 3bn shortfall in VAT and corporation tax receipts was a higher- than-expected level of borrowing at the start of the current financial year.
The slowdown at the end of last year and beginning of this year have forced the downgrade in the growth forecast. Most independent economists thought the 3 per cent prediction made last November was unduly optimistic. But Mr Clarke will predict that the economy is about to pick up strongly, aided by higher consumer spending and a recovery on the Continent boosting exports.
"The Treasury can say that things have been slower than they thought but will improve from now on," said David Walton, an economist at Goldman Sachs. He said a forecast of growth this year of anything up to 2.5 per cent would be plausible, although that would leave the Treasury with one of the most optimistic outlooks.
"They will show the economy reaching what is effectively a policy target of 3 per cent growth in the first half of next year," Mr Martin said.
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