Osborne opts for 'tough but fair' tactic

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George Osborne will lift 880,000 low-paid people out of the income tax net today as he unveils what he will call a "tough but fair" Budget that will squeeze state benefits and public sector pay and pensions.

In his emergency Budget, the Chancellor will promise to spread the pain fairly throughout society. He will publish figures showing that the top 10 per cent on the income scale will pay proportionately more than the poorest.

Mr Osborne will raise the tax-free £6,475 personal allowance by £1,000 to £7,475, a first step to the Liberal Democrats' goal of raising the income tax threshold to £10,000. Nick Clegg will trumpet the move as evidence that his party has shaped today's measures.

Although the Chancellor will announce tough government spending limits for the next four years, he will pledge no further cuts in capital spending such as the school building programme. He will give companies an incentive to recruit by saying that they will not have to pay national insurance for 650,000 low-paid workers.

A ComRes survey of 145 business leaders for The Independent found that seven out of 10 believe the negative effect of the cuts will be felt for at least a decade. A majority (60 per cent) believe that public sector workers will be worst affected by the cuts, ahead of families (8 per cent). More than half (55 per cent) trust Mr Osborne to make the right cuts to secure economic growth. But only 31 per cent believe a Tory government would have made better decisions on where to cut than the Lib-Con coalition.

Mr Osborne hopes his "fairness" measures will sugar the pill, but it will remain bitter for many public sector workers and those who rely on benefits. Treasury officials have advised ministers to consider raising state benefits in line with the consumer prices index rather than the retail prices index. The controversial plan would normally cut the annual rise in benefits by about one percentage point and shave £1bn off payments.

Alistair Darling, Chancellor until last month's election, said the proposal was "lying around" in the Treasury, which "all the time is looking at measures to reduce expenditure". He would be "astonished" if Mr Osborne did not raise VAT, despite saying during the election that he had "no plans" to do so.

Mr Osborne will announce a levy on the banks and shake up capital gains tax to stop high earners disguising income as capital to reduce their tax bills from 50 to 18 per cent.

In a message to Liberal Democrat supporters, the Deputy Prime Minister, Nick Clegg, acknowledged that making cuts would be difficult, but insisted that action was necessary to prevent the sort of problems afflicting Greece and Spain. He rejected charges that he had “sold out” to the Conservatives and made clear that the Liberal Democrats were fully behind Mr Osborne’s Budget strategy.

“We have taken the difficult decisions with care, and with fairness at their heart. You will see the stamp of our Liberal Democrat values in the Budget. But nonetheless, it will be controversial,” he said. “This is one of the hardest things we will ever have to do, but I assure you, the alternative is worse: rising debts, higher interest rates, less growth and fewer opportunities.”

Mr Osborne's "we're all in this together" mantra would be questioned if he raises VAT. A leading Tory activist urged him not to increase VAT until he had considered cutting the NHS budget, winter fuel payments to well-off pensioners, Britain's payments to the EU and higher spending per head of population in Scotland and Wales. "Britain's fundamental problem is its bloated state. We are not under-taxed," said Tim Montgomerie, editor of the ConservativeHome website.

Ministers are sensitive to criticism that they have no "growth strategy" but David Cameron told MPs: "Without confidence, there will be no growth."

The possible changes and how they will affect you

Raising tax thresholds for the lower paid by £1,000 to £7,475

Who will it affect?

Anyone in work and earning a below-average salary would benefit from this. The longer-term goal is to take anyone on less than £10,000 out of income tax – a key Liberal Democrat objective.

How likely is it to happen? Extremely.

Raising VAT to 20 per cent

Who will it affect?

Everyone, and it will probably be pre-announced for 1 January. Each percentage point hike raises £4.1bn. It is a regressive tax, even though some items are zero-rated and domestic fuel is on a 5 per cent rate. Mr Osborne may want to improve benefits to compensate the poorest. It will push the cost of living up by about 2 per cent.

How likely? Fairly.

Raising capital gains tax to 40 per cent

Who will it affect?

Hardly anyone, directly. Only 0.5 per cent of taxpayers encounter it, and around 5,000 individuals make up the bulk of the yield. It has become totemic for both wings of the coalition. The Liberal Democrats want to use it to pay for their tax cut for the low-paid; Tory backbenchers dislike it. It may be subject to the "generous" exemptions for entrepreneurs promised in the coalition agreement, or sent off for review.

How likely? Moderately

Downgrades to growth and unemployment forecasts

Who will it affect?

Everyone, especially those in the public sector worried about losing their jobs. Sir Alan Budd's Office for Budget Responsibility will publish fresh growth forecasts to go with the new Budget. They're likely to show that Mr Osborne's measures will slow growth and may push unemployment towards 3 million.

How likely? Near certainty

Cuts to departmental budgets of 30 per cent

Who will it affect?

Anyone who uses public services. Some areas, such as NHS spending, Overseas Development and the replacement for the Trident nuclear deterrent are "ring-fenced" under the coalition agreement. The Government also promises to restore the earnings link with pensions from next year, an expensive commitment. It all means those developments that are unprotected will suffer even larger cuts than the generality of the public sector. Transport, housing and schools are likely to be hit the hardest.

How likely? Just short of certain