The Government risked a fresh clash with unions today after the Chancellor announced plans to cap public sector pay rises to 1% when a current wage freeze ends.
George Osborne told MPs that further restraint on public sector pay was needed from 2013/15, saying the Government could not afford a 2% rise assumed by some departments.
Local government and health workers are among millions of public sector workers whose pay has been frozen for two years, which has worsened the bitter dispute over pensions.
The Chancellor also announced he has asked the pay review bodies to consider how public sector pay can be made "more responsive" to local labour markets.
Unions believe this is a move towards regional pay rates, something they will strongly oppose.
"This is a significant step towards creating a more balanced economy in the regions that does not squeeze out the private sector," said the Chancellor.
Mr Osborne said the current two-year pay freeze will come to an end next spring for some workers and during 2013 for most public sector employees.
"In the current circumstances the country cannot afford the 2% rise assumed by some government departments thereafter. So, instead, we will set public sector payawards at an average 1% for each of the two years after the pay freeze ends.
"Many are helped by pay progression - the annual increases in salary grades that many people are entitled to, even when pay is frozen. It is one of the reasons why public sector pay has risen at twice the rate of private sector pay over the last four years."
The Chancellor said he accepted that a 1% average pay rise was "tough", adding that it was fair to those who worked to pay the taxes that will fund the increase.
The pay review bodies will be asked to report back by next July on different local labour markets.
Restricting pay rises to 1% will save more than £1 billion by 2014-15, MPs were told.
Bob Crow, leader of the Rail, Maritime and Transport union, said: "George Osborne has ratcheted up the class war and has made it clear through his attack on pay and employment rights that he wants the workers to keep taking the hit while the rich get richer.
"After two years of a freeze, pay for millions of key workers will go up by 1% in the next two years.
"With inflation over 5%, and the increase in pension contributions, that means nurses and the others we rely on will be around 25% worse off after four years of this ConDem Government while top bosses' pay goes up by 12% a year. That's a scandal."
Dave Prentis, general secretary of Unison, said: "Our recovery is as non existent as the Chancellor's apparent understanding of economics. Growth has stalled, and experts are predicting the double dip will hit. What will it take for the Government to realise Plan A is failing?
"We desperately need to get Britain spending. A bad situation will only be made worse by imposing a £3.6 billion tax on public sector pensions, by holding down public sector pay, and by throwing hundreds of thousands of public service workers onto the dole.
"It's time to drop the public sector pensions tax and take steps to put money back into people's pockets. This will boost growth and get Britain hiring - as it is, the private sector is in no position to dig the country out of trouble.
"Not only is austerity hitting growth - the way it is being applied means unfairness is growing. The Government's cuts and austerity agenda is hitting women, the young, and making those who are less able to pay plug the deficit. Meanwhile it is still billions in bonuses for bankers. This is only storing up trouble for the future."