The pain of tax increases totalling almost £33bn during the next five years will be spread across all income groups, according to the Government's plans.
George Osborne, the Chancellor, insisted the better-off would be hit hardest by the austerity package because middle-class families would lose tax credit payments and capital gains tax would be increased for top-rate taxpayers.
But he provoked Opposition fury by announcing that the rate of VAT – regarded by critics as the most regressive tax – would rise from 17.5 per cent to 20 per cent next January.
Labour claimed he was meting out the toughest treatment to Britain's poorest areas because of the combination of the VAT rise and cuts to public spending and to benefit rates.
The VAT increase represents a major economic gamble by Mr Osborne as he is betting on the economy recovering sufficiently by the new year to withstand the sharp increase.
The Tories insisted during the general election campaign that they had "no plans" to put up the VAT rate, while the Liberal Democrats campaigned strongly against any increase. Both parties yesterday explained that they had changed their minds because of the scale of the debt crisis facing Britain.
Struggling to be heard over Labour jeers, Mr Osborne told the Commons: "The years of debt and spending make this unavoidable."
The attraction to the Treasury of increasing VAT is straightforward: the sales tax raises large amounts of cash simply and quickly. It calculates that an extra £12.1bn will be raised in 2011-12 as a result of the increase, rising to £13.5bn in 2014-15.
The tax bills faced by some of the lowest-paid workers will be lowered following the increase in the minimum income tax threshold from £6,475 to £7,475.
Some 880,000 employees will be taken out of tax altogether by the move which is a step towards the Liberal Democrats' ambition of raising the income tax threshold to £10,000.
At the other end of the scale, more people will be dragged into the 40 per cent tax band because Mr Osborne is freezing the threshold at which the top rate of tax kicks in.
A series of cuts to tax credits will be mainly targeted at payments to middle-earners, cutting payments to families earning about £26,000 a year. The overall impact will be to reduce the bill for tax credits by more than £3.2bn by 2014-15.
Mr Osborne said low-income families would also benefit from a rise in the child element of the child tax credit. The coalition reached a compromise over the contentious issue of capital gains tax (CGT), which the Liberal Democrats wanted to raise from 18 per cent to 40 or 50 per cent.
In the face of Tory backbench warnings that savers and entrepreneurs could be unfairly hit by a blanket rise, the Chancellor announced it would go up to 28 per cent for higher-rate taxpayers and remain at 18 per cent for basic-rate taxpayers.
According to the Treasury, the overall impact of all the changes to taxes and benefits would leave the poorest 10 per cent of people just under £200 a year worse off by 2012-13 and the wealthiest tenth almost £1,600 out of pocket. The average household would be slightly more than £400 worse off.
Labour retorted that the figures were misleading as they did not take into account the impact of cuts to support for families that would come fully into effect after 2013.
The increase in VAT was the first change in its rate since Norman Lamont increased it by 2.5 percentage points in 1991, apart from a year-long cut to 15 per cent by the last government in an attempt to nurture economic recovery. News of the rise in VAT was tempered by a promise that food, children's clothes, books and newspapers would remain exempt from VAT for the lifetime of this parliament. VAT on gas and electricity will remain at 5 per cent.
Ed Balls, the Labour leadership contender and shadow Secretary of State for Education, said the increase in the main rate of the sales tax would be "deeply unfair".
He said: "It hits the poorest families the hardest including pensioners and the unemployed who don't pay income tax or national insurance."
Stephen Robertson, the director general of the British Retail Consortium, said the increase would "hit jobs, consumer spending, the pace of recovery and add to inflation".
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