Plans to raise the top rate of income tax for high earners from 40p to 45p in the pound will be announced today as Gordon Brown makes a decisive break with the policies of the Blair era.
In his crucial mini-Budget, the Chancellor Alistair Darling will say that the higher rate would be introduced after the next general election – so as not to break Labour's manifesto pledges since 1997 not to raise income tax rates. The proposed new top rate is expected to apply on incomes above £150,000.
Mr Darling will that "fair" tax increases will be needed to bring the public finances back into balance in the medium term.
He will disclose that government borrowing will rocket to almost £200bn over the next two years to fund an £18bn "fiscal stimulus" – including tax cuts – designed to ensure a "short and shallow" recession.
The Chancellor will predict that public borrowing will soar to £76bn in the financial year as the Government's revenues plummet, and then increase to a record £118bn next year as the recession bites. The worse-than-expected figures dwarf his forecasts in the Budget in March, which were £43bn for the current year and £38bn for 2009-10.
A temporary reduction in VAT, from 17.5 per cent to 15 per cent, will take immediate effect in the hope of boosting consumer spending during this Christmas period. It is expected to last until March 2010. But some Labour MPs are worried about using £15bn of the stimulus to cut VAT because items such as food, public transport and children's clothes are already exempt. People who buy goods such as televisions and adults' clothes would benefit.
Mr Darling will pledge to bring borrowing under control in the medium term through a combination of tax rises, sales of government assets, cutting Whitehall waste and a small slowdown in the planned growth in public spending. Ministers admitted there would be "pain as well as gain".
The Chancellor will forecast that the economy will contract by more than 1 per cent in 2009 but would bounce back sharply in 2010. Mr Darling will target cuts in personal taxation at people on low incomes, including those who lost out from the abolition of the 10p tax rate. He is also expected to help pensioners and motorists.
Some Labour MPs pointed to how huge high street sales last week on VAT-rated items had failed to bring in shoppers, and they fear that a reduction in VAT will have little impact. John McDonnell, who chairs the left-wing Campaign Group of MPs, said: "VAT can form an element of the plan, but it must not be the central element. What we should be doing is targeting measures at the very poorest, who need the help the most. That should mean injecting cash into the economy by helping pensioners, those on benefits and taking people with very poorly paid jobs out of the tax system."
Other Labour backbenchers argue that in times of financial difficulty, shoppers are quick to begin saving money by shopping around and targeting sales, which pushes down costs. "Lowering VAT is not the most sensible way of doing this," said Paul Flynn, the MP for Newport West. "There is going to be plenty of scope for savings provided by shops over the coming months."
David Cameron, the Tory leader, was "highly sceptical" about the VAT cut. "The Government is giving with the one hand and is going to take away with the other hand," he said, "and VAT will soon go back up again and other taxes probably up by more."
Vince Cable, the Liberal Democrats' Treasury spokesman, said: "What we really need is permanent, fully funded tax cuts targeted at those on low and average incomes, through reductions in income tax, rather than giving a temporary VAT cut, which will primarily reward the big spenders who have loads of money."
Ministers will argue that the VAT cut will help all households and that poorer families are more likely to spend the money returned to them in tax cuts than the better off. They will cite support for the move from Kenneth Clarke, the former Conservative chancellor.
Mr Darling will also unveil a "green industry". He plans to reduce household energy bills for a further 60,000 low-income homes through loft insulation and better heating systems; the delivery of 200 trains to be speeded up; and the rail network's capacity to be expanded.
The Chancellor is to expand by £1bn a scheme to underwrite loans of between £1,000 and £1m to small firms, with the risk shared by the Government and banks. A new payment support service will allow small companies to delay tax payments to HM Revenue & Customs. A three-month grace period for people in trouble with mortgage payments is expected to limit the number of home repossessions.
Gordon Brown denied that the package was a gamble and will argue today that to not act now would be "a failure of economic policy" and "a failure of leadership". The Prime Minister will tell the CBI's annual conference in London that "in previous recessions a failure to take action at the start of the downturn has increased the length and depth of the recession ... Doing 'too little too late' would mean more damage, more deterioration – a weaker economy, lower growth, eventually greater fiscal problems and in the event, higher interest rates and higher taxes."