Chancellor George Osborne risks missing his target of eliminating Britain's national deficit by the next general election because of below-par growth and "formidable" difficulties delivering cuts, a respected economic thinktank warned today.
The Institute for Fiscal Studies' annual Green Budget had good news for the Chancellor in the short term, predicting he will need to borrow £2.9 billion less than expected this year.
But it warned Mr Osborne not to use this cash to fund tax give-aways in his March 23 Budget, but to "bank" the money to help deal with risks further down the line.
The tax breaks advocated by some business groups to help boost growth could prove "ineffective" because they would risk triggering rises in interest rates to rein in inflation, said the IFS.
And the thinktank warned that any fiscal loosening designed to help the economy could undermine investor confidence that the Government will see its cuts strategy through.
Following "disappointing" figures last week - which showed GDP shrinking by 0.5% in the last quarter of 2010 - growth over the medium term is likely to be lower than predicted by the Office for Budget Responsibility (OBR), whose forecasts are used by the Chancellor to plan his Budget, warned the report.
Analysts from Barclays Wealth and Barclays Capital - which prepared the report in collaboration with the IFS - said the economy was likely to grow roughly in line with the OBR's 2.1% forecast for 2011.
But they warned that in following years, growth was likely to be less than the OBR forecasts, with a projected deficit on the cyclically-adjusted current budget of 0.4% of national income in 2015/16.
This would mean that "current policy would not be consistent with the Chancellor's fiscal mandate" of paying off the deficit by the election, said the report.
Only an "optimistic" view of the future would see the economy developing as the OBR expects and Mr Osborne meeting his targets, said the Barclays experts Michael Dicks and Simon Hayes, while a "pessimistic" view would see public sector net debt still rising in 2015/16.
Meanwhile, the report warned that the Government's package of £81 billion cuts in public spending could be "formidably hard to deliver".
The cuts are "more ambitious" than those imposed by John Major's administration in the early 1990s and will be more difficult to achieve, said the IFS.
And they highlighted areas such as the Home Office and Ministry of Justice where the staff reductions envisaged by ministers "will be difficult to achieve cost-effectively on the proposed timescale".
"Overall, with such large downside risks to the public finances, having alternative plans to hand could prove useful," said the report.
"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 that are palatable to the Government and the wider public."
A Government source said the IFS's warning to avoid fiscal loosening in the forthcoming Budget was in line with the insistence of the Chancellor and Prime Minister David Cameron that the Government must see its economic plans through.
"The IFS have made it clear that the Government should resist calls to loosen fiscal policy, saying that it could be 'ineffective'," said the source.
And the Conservative Party pointed out that it is Labour's Ed Balls - and not the Chancellor - who has called for the austerity measures to be relaxed, arguing that the cuts are too deep and too fast.
"The IFS backs the Government's strategy and demolishes Labour's economic argument," said a Conservative spokesman.
Responding to the IFS report, the Prime Minister's official spokesman said: "We have always been clear it is going to be a difficult process, but it is a necessary one, given the scale of the deficit."
The IFS said this year's faster-than-expected reduction in borrowing will give Mr Osborne leeway to ease his austerity package by £4 billion in his March budget - the equivalent of 0.3% of GDP by 2015/16.
But it warned that offering tax or spending give-aways at this point would be "hasty".
"Given the uncertainties facing the UK economy and public finances, our judgment is that Mr Osborne should refrain from announcing any net permanent give-away in his March Budget."
The Chancellor should instead prepare an "alternative plan" in case the economic outlook worsens in the years ahead, said the think-tank.
"Any improvements in the public finances ... might best be banked to give the Government additional headroom against a future worse outlook for the economy or the public finances or a need to top up its challenging plans for cuts to spending on public services," said the report.
"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 IFS rated the likelihood of a double-dip recession during 2011 at 20%, but assessed that a year of "sluggish" growth was more likely.
OBR projections for the next five years were "optimistic, both in terms of the speed at which spare resources get used up and as regards the economy's potential growth rate", said the report.
The OBR projection over-estimated likely growth by a cumulative 1.5% over that period, according to the IFS forecasts.
The IFS expected only "mild acceleration" in GDP growth over the next few years, reaching its "long-term sustainable rate" of 1.75% no earlier than 2014 - considerably later than the OBR forecast.
"We continue to worry that the official view of future prospects, as contained in the OBR's analysis, is overly complacent about both future inflation risks and the scale of the required fiscal consolidation," said the report.
"Relative to a year ago, however, the gaps between our own and the official forecasts are now a lot smaller."
The Government's planned cuts amount to the tightest five-year period for public spending since the Second World War, with only Ireland and Iceland wielding the axe more savagely, noted the report. Only Greece, among leading industrial nations, is planning to reduce borrowing by more.
"The OBR judges that current policy is consistent with the fiscal mandate, and forecasts that the supplementary target is more likely than not to be met," said the IFS.
"But if the OBR's forecasts are as accurate as past Treasury forecasts, there would still be a three-in-10 chance that further tax rises or spending cuts would be required to avoid a cyclically adjusted current budget deficit in 2015/16."
The IFS did not expect interest rate hikes in the short term, but said the Bank of England's ability to provide additional support to the economy would be constrained by high inflation.
"It may therefore make sense for the Government to consider ways of reducing the pace of fiscal consolidation should demand conditions deteriorate significantly - enabling it to 'trim the sails' again in the same manner that it did so last November," said the report.
Responding to the report, TUC general secretary Brendan Barber said: "The IFS analysis shows what a risky gamble the Government is taking with the economy.
"The fastest and deepest cuts of any major country are slowing the economy, which risks making the deficit bigger rather than smaller.
"Only economic growth and getting the jobless back to work can bring the deficit down in a way that does not do huge damage to the fabric of our society.
"The IFS is right to say that we need a plan B."