Watch that squeeze ahead

A significant tax rise will be required, to fund even the modest increases in government spending pr

For more than a decade, Gordon Brown won his annual game of chicken with the City scribblers. Each year he would forecast in his Budget that the public finances would meet the strict fiscal rules he set soon after new Labour took office. And each year without fail the City economists and experts would dispute the chancellor's arithmetic. Yet by hook or by crook Brown managed to bring the numbers in on target without breaching his rules.

As Alistair Darling, still scarred by the Northern Rock debacle, prepares to deliver his first pre-Budget report, few would bet on him pulling off the same trick. Events are moving against him. Latest numbers suggest a sharp decrease in tax receipts. The Chancellor will need to deliver on a fierce clampdown on public spending. He also needs to inject some credibility into a system of fiscal monitoring now regarded with great suspicion by analysts.

Brown was able to meet his targets by luck and sleight of hand. His good fortune was that the British economy grew most years at a faster clip than forecast. This meant that companies, the financial services and consumers produced fatter tax receipts than expected.

When his rules looked in danger of being breached, he moved the goalposts. The golden rule, which required the Treasury to keep spending on services in balance over the cycle, was achieved by stretching the reference period backwards and then forwards. The economic cycle turned out to be the longest in memory. Moreover, in the face of sniping from the City and the Tories, the Brown Treasury steadfastly managed to keep two great chunks of public investment, spending under the private finance initiative (PFI) and the huge liabilities of public sector pension funds, off government books.

Latest figures point to the great problems that Darling has inherited from his predecessor. In August, overall government borrowing reached an alarming £9.1bn, a record for the month, against £6.7bn for August last year. The size of the shortfall makes it highly unlikely that the Chancellor will have any chance of meeting the deficit forecast of £34bn for the current fiscal year - unless he increases taxes, which looks highly unlikely in the present fevered election atmosphere.

So what is going wrong? In the first instance tax receipts are sharply down. Income taxes and VAT receipts are holding up reasonably well, if slightly below forecasts. The big hit is coming from the taxes paid by companies, which in August were freakishly 44.9 per cent lower than in the same month last year and are at present down by 3.1 per cent for the first five months of this financial year.

With the City in the doldrums after this summer's credit crunch and the economy likely to slow in the second half of the year - after robust growth of 3.1 per cent in the first two quarters - the targets for tax receipts look unrealistic. It will be hard for ministers to make up ground by holding down spending, which is already above target.

The really tough part is yet to come. In his last Budget as chancellor, Brown made clear that Labour's days of big spending are over irrespective of how buoyant the tax receipts are. The spending review for the next three years, 2008-2011 (to be released with the pre-Budget report), will hold the growth of public spending to just 1.9 per cent, around one-third of the increases in recent times. Labour's spending bandwagon is due to come to a shuddering halt.

Darling is also having to grapple with unfinished business. Slowly but surely, PFI spending is being brought back on to the books. In August, for example, the government was required to add back £0.3bn to public debt, to cover the cost of the implosion of Metronet, the public-private partnership responsible for the modernisation of London's Tube.

So far Labour has managed to pass its own fiscal rules. Surpluses on current spending are estimated to be £18.7bn over its decade in power. Similarly, in every year in office - except 1997-98 - it has managed to keep public sector debt below the 40 per cent level.

But the pressure is growing. Think tanks such as the Institute for Fiscal Studies and the National Institute of Economic and Social Research are calling for a redefinition of the golden rule to end the cheating. Meanwhile, the government faces a fight with public sector unions over the nasty squeeze ahead. But it is the macroeconomic situation that is most worrying. Booming tax receipts, much of this from the banks and financial sector, are likely to plunge this year, delivering a sea of red ink. Meeting the public borrowing target will be all but impossible.

A significant tax rise will be required, to fund even the modest increases in government spending projected, if the public finances are not to go awry. Economic stability and fiscal prudence are no longer Labour's political ace-in-the hole.

Alex Brummer is City editor of the Daily Mail