High stakes in Gordon's game of tax and spend

Gordon Brown's Budget was the first trick in a furious game of political cards. Already, the Tories have promised to match Labour's pre-election treats for pensioners, children and first-time buyers, and add a few more of their own.Brown responded by warning that shadow Chancellor Oliver Letwin would jeopardise the public services with £35 billion of 'cutbacks' by 2011.

The tax-and-spending battle will hot up as election day approaches, with the parties swapping tantalising promises and dire warnings. But as far as economy-watchers were concerned, very little changed on Budget day.

Brown's forecasts on the public finances remained almost unaltered, as did the scepticism about whether he can meet them. There is a consensus that he will be forced to raise taxes, if he is still at the Treasury after the election, to meet his own spending rules over the next economic cycle.

'Whoever is at the Treasury after the election will have a rather difficult wicket to bat on,' said Roger Bootle, economic adviser at Deloitte and Touche.

The Chancellor is expecting his tax revenues to increase by £25bn a year by 2007-08, without having to increase tax rates. Experts at the Institute of Fiscal Studies - and almost every other think-tank and forecaster, from the International Monetary Fund to the Item Club - think he's being too optimistic, even if he's right that the economy will continue to grow at a healthy pace.

Letwin will warn voters repeatedly between now and polling day that they will find themselves footing the bill for the Chancellor's profligacy; but that means Letwin has had to make provision in his own plans to fill Brown's 'black hole'. That has left the Conservatives only £4bn for their own package of tax cuts - though as the Treasury's spending plans are the starting point for Letwin's, he says he can bank Brown's pre-election largesse and pile his £4bn on top.

Brown was defiant last week about his record of forecasting economic growth, but on predicting the path of the public finances, the Treasury's history is less impressive. IFS director Robert Chote pointed out that at the time of the 2001 Budget, Brown was expecting to have to borrow just £4bn over the four years of this Parliament. The real figure turned out to be £95bn. He is now expecting to meet the golden rule when the economic cycle ends next year with a margin of just £6bn to spare.

With his room for manoeuvre thus severely restricted, the package of giveaways the Chancellor cobbled together was less generous than many analysts had predicted. Chote described it as 'commendably restrained' for a pre-election Budget, and compared the small fiscal tightening this time with a £3.5bn giveaway in 2001, before the last election, when there was more cash to go around.

Pensioner households will get a one-off £200 payment to help them afford their Council Tax, low-income families will receive a boost from higher child tax credits, and the stamp duty threshold on house purchases will double, to £120,000. Free local bus travel and a statue of the Queen Mother completed the bid for the coveted 'grey vote,' which the Tories have also been keen to win.

These modest handouts were more than offset by higher tax revenues. Changes to the timing of oil company tax payments brought £1bn forward into this fiscal year, and exemptions on stamp duty for commercial property in deprived areas were removed, bringing £350m back into the Treasury. There was also a long list of tax avoidance measures - a favourite ploy of Chancellors in tight corners.

'If this is all he can do to fight an election, it shows how difficult things are,' said Peter Spencer, of the Ernst and Young Item Club.

John Butler, chief UK economist at HSBC, said Bank of England governor Mervyn King was probably at the back of Brown's mind when he was drawing up his sums. The Bank's Monetary Policy Committee believes there is less slack in the economy than the Treasury thinks, and a profligate Budget could have tempted them to make an early increase in borrowing costs, potentially wiping out the benefits to homebuyers of the rise in the stamp duty threshold.

There is what Butler calls a 'tension' between the Bank's expectations and the Treasury's - Brown is expecting growth to remain strong and bring the tax receipts rolling in but the Bank's forecasts suggest that an acceleration in growth would be accompanied by higher inflation and an increase in rates.

'Something's got to give,' said Butler. 'Either the Bank's forecasts are wrong, and rates will go up more, or the Treasury's forecasts are wrong, and they will have to borrow more.'

Even if the Chancellor is right about growth, he has already raised eyebrows with his quiet 'anti-avoidance' raid on British businesses. More than half of the extra tax revenue Brown is expecting to bank by 2007 was already due to come from the corporate sector, and tax experts accuse him of stealthily pushing up the price of doing business in Britain.

'It's about the attractiveness of the UK from a competitiveness standpoint,' said David Cruickshank, head of the tax practice at Deloitte and Touche. He said some of the new rules were legitimate anti-avoidance measures, but some were changes in the tax system, and called for government to hold a dialogue with businesses about how much of the tax burden they should be expected to bear.

Brown did offer businesses a quid quo pro for dipping into their pockets to fund his pre-election giveaways. As well as benefiting bus-riding pensioners, the Budget contained a slew of 'pro-business' measures. The Hampton review of business regulation offered a radical recipe for merging more than 30 regula tory bodies, from the Environment Agency to the Hearing Aid Council, into just seven, following the trail blazed by the mega-media regulator, Ofcom, and the Financial Services Authority. Business groups welcomed the prospect of dealing with a slimmed-down army of regulators, and filling in fewer forms.

But Spencer, of the Ernst and Young Item club, said the Budget also gave a clear hint as to where Brown would dig for extra revenue if he is still at the Treasury in a year. 'He's taking £2bn here, £2bn there. It's oil companies this time, but it could be banks next. He's going to scrape and scrape away.'

And that's what Letwin has to convince the voters as the election campaign proper kicks off: that Labour will be asking for more cash next year, and the year after that. He has a few more tax-cutting presents up his sleeve - £2.7bn-worth to be precise - but he plans to pay for them with a radical efficiency drive, much of which Labour claims is unworkable. The forecasters are no more confident about the Conservatives' chance of achieving their waste-cutting targets than about Brown's ability to pay for his long-term spending plans. In the end, as the tax-cutting cards fly back and forth, the decision for voters will come down to the old-fashioned question of trust.