Revealed: Labour's £37bn stealth spending cuts

Institute for Fiscal Studies identifies slashed services and 45 per cent tax rate myth

Stealth spending cuts by the Government will see £37bn slashed from frontline public services, according to analysis of the pre-Budget report by the respected Institute for Fiscal Studies. Meanwhile the Organisation for Economic Co-operation and Development has forecast the UK economy will shrink more sharply than any other G7 country next year, in a "severe" downturn losing 1.1 per cent of GDP.

The IFS, in its new report, says the Treasury's planned 45p rate of tax for higher earners will raise "approximately nothing". In a withering verdict on Alistair Darling's proposals, the Institute's experts say average earners will be worse off after 2011 than they are now, contrary to ministers' claims. The IFS also dismisses the Chancellor's new "temporary operating rule", designed to replace the old fiscal rules, because it "doesn't really impose any restraints on borrowing".

The report says the Treasury is "strictly correct" to say no one earning less than £40,000 will be worse off as a result of the increases in national insurance and other tax changes being brought in in 2011. But it says this is only true if the position in April 2008 – ie before increased personal allowances of £600 per year – is ignored. If these are taken into account, and the comparison made with what average earners are paying in tax and national insurance today, then anyone on more than £20,000 a year will be worse off, says the report. This would take in large swaths of "middle England".

Despite rises in personal taxation, however, the IFS says most of the burden of rebuilding public finances will fall on public spending. The IFS highlights that public spending is now expected to grow by just 1.1 per cent in real terms between April 2011 and March 2014. Public sector investment – new schools, hospitals and other infrastructure – will be sliced by 16.5 per cent in 2012-13, compared to previous plans. As one example, though the Department of Health's capital budget is set to increase by £300m in 2008-09 and 2009-10, the following year will see a reduction of £1.4bn.

The IFS says public expenditure will drop 2.5 per cent as a proportion of national income by 2012-13 – equivalent to £37bn less than the currently–budgeted forecast. Yet when the Conservatives went into the last general election with a similar pledge – to trim public spending plans (but not actual levels of public spending) by £35bn – they were roundly condemned by the Labour Party. At that time Mr Darling said such changes were "so large they could only be found from cutting deep into frontline public services, including schools, hospitals and the police." The director of the IFS, Robert Chote, said yesterday: "The Chancellor announced a short-term fiscal stimulus designed to limit the depth and duration of recession, followed by a long-term fiscal contraction designed to recoup the costs of stimulus and – more importantly – to repair a dramatic deterioration in the underlying health of public finances."

The IFS says the credit crunch and economic downturn will mean a permanent loss of 4 per cent of GDP – £60bn – and has punched a £40bn hole in the Government's finances.

The minutiae of the Treasury's new tax rules has also created a bizarre 60 per cent marginal rate of tax for a very small number of wealthier taxpayers. On the slices of income falling just between £100,000 and £106,450, and on the slice between £140,000 and £146,450, the change to personal allowances means those taxpayers will pay 60p in the pound on that part of their earnings, in the words of the IFS, "for no obvious economic rationale".

The IFS stresses that while the Treasury itself estimates the new 45p rate will raise £1.6bn in a full year – a comparatively small figure in a total tax take of £545bn this year – it has cause to think the yield may be even smaller, or could even result in a loss, depending on the behaviour of this usually financially sophisticated community. The IFS judgement is based on empirical evidence which suggests that once a total tax take reaches about 56p in the pound (including taxes on spending such as VAT), there is a "tipping point" that makes the yields from a tax hike extremely uncertain. Taking into account such consumption taxes, the 45p rate would see the rich losing around 59p in the pound in tax.

The IFS also argues the Treasury may have overestimated the losses it will suffer from the reduction in VAT. The Institute's researchers argue the Governor's figures oddly assume there will be no change in people's behaviour – so that they will spend no more after the tax cut than before.