Andrew Dilnot and Carl Emmerson: The crunch may be not be soon, but it may still be painful, Mr Brown

'For public spending to grow as planned in the last two years of this Parliament, taxes must rise by £5bn'

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Disaster for the public finances, taxes to rise, public spending reined in, prudence in despair. Is it really that bad, or is some of the discussion of the impact of 11 September on the choices facing the Prime Minister and the Chancellor on the economy getting a little over excited?

There is little doubt that we will now see higher public spending and lower tax revenue than we would have expected before the attacks on New York and Washington. Public spending will be higher because of the direct impact of increased spending on defence and public order and also because it seems likely that the economy will grow less quickly, which will mean higher spending on social security. Taxes will be lower because of the effect of slower economic growth.

So how should the Government react? Must they cut spending plans or raise taxes, or can they simply allow borrowing to rise?

The Labour Government has set out and stuck to what it calls the golden rule of public finances: that governments can borrow, but only to invest. These rules are to be assessed over the economic cycle, so that, in periods when the economy is underperforming, the Chancellor is allowed to borrow as long as this is repaid in more prosperous periods.

At the moment the Government is much more than meeting this rule, with a surplus of £23bn in the last financial year and a forecast at Budget time of a surplus of £16bn for this year. But that surplus is forecast to decline as the rapid spending growth planned for this year and the following two years is implemented. The rule will only just be met in 2003-4. Does this mean that the Government should not borrow more to pay for its response to the attacks on America?

Surely not. In whatever way the financial implications resulting from any conflict are actually defined, the very process seems to have all the characteristics of an investment. Protecting societies and cultures is surely about spending now to provide returns in the future.

Given the scale of the surplus currently being run, spending more this year may mean simply running a smaller surplus rather than seeking funds. Any change this year is unlikely to be large relative to the £10bn average error in forecasting public-sector borrowing one year in advance. Given the likely slowing of the economy, it is unlikely that additional government spending and borrowing would have a large inflationary impact in the short term.

For now at least, the Government probably shouldn't worry too much about the financial implications of any conflict and should be happy to bear the cost without any cuts in public spending or rises in taxation.

But in the slightly longer term the Government faced some rather difficult choices over public spending and taxation anyway. Planned public spending is now growing rapidly, especially in health and education, where it is expected to grow on average, in real terms, by 5.7 and 5.6 per cent per year respectively over the three years from April 2001.

This is much more rapid than the growth in the economy or the growth in tax revenue. Such fast growth in public spending is possible because of the very low growth in spending in the earlier years of the last parliament and the significant increase in taxation that occurred between 1996-97 and 2000-1.

But by 2004-5, which is the first year of the new plans that Mr Brown must announce in the March 2002 Budget, the fruits of the last parliament's spending restraint and tax increases will have been used up.

Even before 11 September, Mr Brown faced a choice. If public spending was to continue to grow more quickly than the overall economy, taxes or borrowing would need to rise. Increasing borrowing in 2003-4 seemed likely to break his own rules, so taxes would need to rise to meet rapid growth in public spending.

If the last two years of this Parliament see public spending continuing to grow as planned, then tax revenues will need to rise by around £5bn in 2004-5 and a further £5bn in 2005-6.

So there was anyway a trade-off to be faced on tax and public spending that looked likely to be uncomfortable. Has anything changed as a result of the attacks on America that might make the situation worse? There are two obvious possibilities.

First, the aftermath of 11 September could mean that the long-run trend growth rate of the UK economy could now be lower than expected. There are a number of ways in which this might be true. It could be that extra costs associated with higher security might make certain activities, especially travel, significantly more expensive in the long run. It could be the case that individuals will persist in being much more cautious, depressing consumer demand systematically. Or it could be true that slow growth for a short period might permanently deprive the economy of some output, so that, although after a period of years growth might return to previous levels, the economy would be on a lower path than before.

All these are possible, but it is important to note that the current official assumption for the trend rate of growth is 2.25 per cent, significantly lower than most estimates of its true value, so as to build in caution. A reduction in the trend growth rate to less than this would imply a very serious impact on the economy.

A second potential problem for Mr Brown's spending plans would be a need for higher defence and/or law-and-order spending in the medium and long run. For many years defence spending fell as a share of total public spending and GDP. In 1984-85 defence spending was 5.2 per cent of GDP, but in 2000-1 it is forecast to have been only 2.5 per cent. That is an annual saving of £26 billion and has allowed higher spending in areas such as health, education and social security. A shift to increasing defence spending would have consequences for other priority areas.

In the short run, the correct response simply seems to be to spend what is necessary without adjusting tax and spending plans, leading to higher borrowing (or a lower surplus). In the medium term, the Government anyway faced some difficult decisions about tax and spending. Tuesday 11 September may make these worse, although it is too early to be sure.

Andrew Dilnot is the director, and Carl Emmerson a fellow, of the Institute for Fiscal Studies