Chancellor George Osborne has scope for temporary tax cuts of up to £20 billion in his March Budget to boost growth, a respected economic think tank said today.
The Institute for Fiscal Studies (IFS) said that the case for cuts to VAT or employers' National Insurance contributions, as well as increased investment, was "stronger now than a year ago".
Expectations of a fall in inflation later this year meant that the Government could increase borrowing by around 1% of GDP to fund a short-term fiscal stimulus without triggering an increase in interest rates, said the IFS.
But the think tank warned that any stimulus package must be "timely, targeted and temporary". There was a "strong case" against permanent tax cuts at this stage, and any larger package would risk unsettling the bond markets and forcing up the cost of Government borrowing.
Labour - which has been calling for a five-point plan to boost jobs and growth, including cuts in VAT and National Insurance contributions, as well as infrastructure investment - welcomed the IFS judgment, contained in its Green Budget.
Shadow chief secretary to the Treasury Rachel Reeves said: "The independent IFS is right to say that the case for short-term action on jobs and growth - for example through the temporary tax cuts Labour has been calling for - is now stronger and will get stronger still if the eurozone crisis deepens.
"But rather than waiting for things to get even worse, George Osborne should take urgent action in next month's Budget. Years of slow growth and high unemployment are not just bad for families and for the deficit, but also risk permanent damage to our economy."
The report predicted that Mr Osborne will beat his deficit reduction target by £3 billion in the current financial year - largely due to Whitehall departments underspending on their budgets.
But it said that prospects for 2012 remain bleak, with predicted growth of just 0.3% - significantly lower than the 0.7% predicted by the Office for Budget Responsibility, which produces the Government's official forecasts.
John Walker, of Oxford Economics, which worked with the IFS on the report, said he was "certainly" expecting a double-dip recession, with negative growth in the current quarter to follow the recently-announced contraction in the last three months of 2011.
The report also warned that a break-up of the eurozone could plunge the UK back into "deep recession", with GDP falling both this year and next and unemployment soaring to a 20-year high.
Mr Osborne should use his Budget statement on March 21 to spell out how he would react if the debt crisis in the single currency deteriorates further, said IFS economist Gemma Tetlow.
The fragile state of the euro meant that the risk of an unexpected development in the economy was "heavily skewed to the downside", and the Government needed to reassure investors that it has the flexibility to respond, she said.
Modelling by Oxford Economics suggests that the departure of up to five countries from the eurozone would result in British GDP shrinking by 1.7% in 2012 and a further 0.9% in 2013, while unemployment would soar to 10.7% - the worst level since 1993.
In the case of a collapse in the euro, Mr Osborne would have to impose further tax increases and spending cuts unless he was willing to abandon his own "fiscal mandate" of balancing the books over a five-year period.
"If the eurozone does break up, pretty much all our forecasts are blown out of the window, as is the Government's fiscal strategy," said IFS director Paul Johnson.
The report said the size of austerity measures planned for the UK were "almost without historical or international precedent" and represent the biggest sustained cuts since the Second World War.
It pointed out that, by the end of the current financial year, just 6% of the cuts will have been implemented, and added: "How deliverable the remainder will prove to be remains to be seen."
But the pressures of an ageing population on health and pensions budgets mean that "further hard choices over tax and spending are likely to be needed".
Mr Johnson said: "The Chancellor faces his third Budget with the economy and public finances in considerably weaker shape than he had hoped a year ago.
"While it looks as though central Government is going to underspend against tight spending plans, this neither leaves much space for any permanent fiscal loosening nor avoids the fact that the vast majority of the planned - and unprecedentedly big - public service cuts are still to come."
A Conservative source highlighted figures in the report suggesting that debt would be £201 billion higher by 2017 under the plans inherited from the last Labour government than expected as a result of Mr Osborne's austerity package.
The report also said the Government should rethink "ill-thought out" plans to withdraw child tax benefit from higher income families.
The proposals create a "cliff edge" beyond which the payment suddenly stops and has suggested that a gradual reduction in the benefit should be brought in instead.
It has calculated that, under current plans, 170,000 families could increase their net income by reducing their pay, while a further 200,000 families could end up worse off if a pay rise took them above the higher tax rate threshold.
And it said that more thought needs to be given to the 50p rate of tax for top earners amid fears it could be counter-productive.