You need a Plan B, influential think-tank tells the Chancellor

The Chancellor needs to prepare a "Plan B" in case the economy continues to slow, according to the independent Institute for Fiscal Studies, which also warns that the Government's cuts to public spending, among the most severe in the world, could prove "formidably hard to deliver".

Some "sensible contingency planning" will be necessary, Carl Emmerson, deputy director of the IFS, said yesterday, "if things turn out to be different for taxes, benefits and the settlements set out in the spending review". The situation in 2012, he added, is "unlikely" to match the situation outlined in last November's Comprehensive Spending Review.

Paul Johnson, director of the IFS, told the BBC: "They really ought to set out what they will do in the face of a significant change in the economy and a significant difference."

The IFS warns that the predictions made by the new Office for Budget Responsibility, set up by the Government, are "optimistic". "The economy might not grow as quickly as the OBR expects, and even if it does the public finances might not bounce back as strongly as it forecasts," the IFS said.

Nonetheless, the IFS agrees that the Chancellor is on track to meet his borrowing targets this year, and may undershoot them by £2.9bn. However, the IFS stresses, "this is in the context of a deficit which we expect to be £145.6bn this year" – the highest since the Second World War.

Stressing the "significant risks" to the economy, and the probability that rising inflation will constrain the Bank of England's ability to pump more money into the economy and keep interest rates low, the IFS said: "It may therefore make sense for the Government to consider ways of reducing the pace of consolidation should demand conditions deteriorate significantly."

The IFS added: "Although there may be no need to implement an alternative plan at this stage, with such large downside risks to the public finances, having alternative plans to hand could prove useful.

"The Government should review its spending settlements in a couple of years' time in light of any changes to the economic and fiscal outlook, or particular difficulties faced by departments in delivering spending cuts."

Economists are divided on whether the Government will reach its longer-term objective of eliminating the "structural" budget deficit by 2015, the part that cannot be explained by the fact that tax revenues are temporarily depressed. Mr Osborne has styled this his "Fiscal Mandate".

Michael Dicks, chief economist at Barclays Wealth, who worked with the IFS to produce its report, said its more pessimistic view of economic prospects meant that "current policy would not be consistent with the Chancellor's Fiscal Mandate".

Earlier this week the National Institute for Economic and Social Research also concluded that the target would be missed, albeit narrowly. The IFS makes a more substantial criticism, however, that the Fiscal Mandate is a moving target and "does not place any constraint on the Government's behaviour in the short run".

The IFS describes the Chancellor's "patent box", which relieves companies of some tax if they register innovations in the UK, as "poorly focused... The jury is still out on whether the policy is the best way to encourage firms to retain the real activity associated with mobile intellectual property in the UK." That judgement coincides with Pfizer's announcement that it is to close its research arm in the UK.

Angela Eagle, shadow Chief Secretary to the Treasury, said: "Without growth George Osborne won't meet his own deficit reduction targets. It's time he heeded those warnings and got himself a Plan B."

Plan B – the options

Trimming the sails

The IFS suggests that the Treasury might repeat the exercise it conducted last year when a fifth of the public spending cuts proposed in the June emergency Budget were transferred from departmental spending plans to cuts in welfare instead, and even some of those were postponed. This would be helpful if the economy performed as expected, but the sheer scale of the cuts to services became impractical.

The George W Bush tax cut

The National Institute for Economic and Social Research suggested this week that tax rebates or a time-limited tax cut would support the economy if things go badly wrong. This was tried in the US, with mixed results; the Tory backbenches might like it.

The Balls way

The Shadow Chancellor Ed Balls is unequivocal: the deficit should be cut, but much more slowly. It would be the biggest U-turn since Ted Heath was in No 10. Unlikely.

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