Treasury fears tax rise could end up making deficit worse

Job creation may be stifled by rise in National Insurance, officials believe

(Reuters)

Treasury officials fear that the surprise increase in National Insurance announced in Alistair Darling's pre-Budget report is a gamble that could backfire by stifling job creation.

Gordon Brown is understood to have insisted that the hike in NI should be the centrepiece of the Chancellor's programme for reducing Britain's debt mountain.

Amid last-minute wrangling over Wednesday's package, the Prime Minister vetoed taking the alternative option of announcing a sharp rise in the rate of value added tax.

It is understood Mr Darling was also prevented from spelling out in greater detail where the spending axe would have to fall if he is hit his target of halving the £178bn national deficit within four years.

The Chancellor announced that the rate of NI would go up from 11 per cent to 12 per cent – 0.5 per cent more than previously announced – for employees.

Business leaders have protested that a parallel rise from 12.8 per cent to 13.8 per cent in employer contributions amounted to a tax on jobs and could thwart recovery.

Senior Treasury sources told The Independent they shared the misgivings of business and industry over the increase. One acknowledged it was a "gamble" that could deter employers from recruiting staff if economic recovery was not well under way by 2011.

Downing Street insisted there had been no split between the PM and the Chancellor, but George Osborne, the shadow Chancellor, accused Mr Brown of "playing politics" with the nation's economic health.

VAT will return to 17.5 per cent next month from its current rate of 15 per cent. But Mr Darling contemplated announcing a further rise in 2011 as a way of signalling to the financial markets that the deficit would be tackled. Under the plans, it would have been accompanied by a compensatory package for those on low incomes.

Mr Brown – backed by his close ally, the Schools Secretary, Ed Balls – argued that a further increase in VAT would have little impact on the wealthy and could depress the fragile retail sector. They also said that announcing such a rise would have prevented Labour accusing the Tories of planning to raise VAT after the election.

Government sources said that the final decision to opt for NI was accepted by Mr Darling. But it worried some Cabinet ministers because it would squeeze middle income groups as well as the highest earners.

In the negotiations over the pre-Budget report, Treasury officials were instinctively sympathetic to demands by Mervyn King, Governor of the Bank of England, for tougher action to cut the deficit. But Mr Darling also had to juggle the competing demands from Mr Brown who, as The Independent revealed on Thursday, wanted a firm pre-election pledge to protect spending on schools, hospitals and police numbers.

Mr Darling's initial instinct was not to ringfence any budget in this way. But the Tories have promised to spend more on the NHS each year in real terms, leaving Labour potentially exposed on one of its traditionally strong issues.

Mr Balls insisted that his department needed a real-terms increase. He argued that he had less scope for efficiency savings that would not affect frontline services than other departments, as the number of primary pupils was rising and much of his budget was being soaked up by teachers' pay.

He asked for a real-terms rise of more than 1.3 per cent, but eventually settled for a 0.7 per cent increase for schools. His fraught negotiations with Mr Darling lasted well into Tuesday night, only hours before the Chancellor formally unveiled his pre-Budget report at Wednesday lunchtime.

One Cabinet minister said: "Ed fought a very aggressive campaign on his own behalf. It often went on until the middle of the night. He got concession after concession."

Andy Burnham, the Health Secretary, considered a 0.8 per cent real-terms rise for primary care, but eventually settled for a simpler formula that would keep his departmental spending in pace with inflation.

Yvette Cooper, the Work and Pensions Secretary, who is married to Mr Balls, proposed lowering to £100,000 the £150,000 point at which the new top 50p rate of tax will bite from April. But that was ruled out after other ministers warned it would be the "straw that broke the camel's bank" for higher earners already protesting about the new top rate.

David Blunkett, the former Home Secretary, called on all parts of Whitehall to rally behind Mr Darling's "deeply ambitious" deficit reduction plans.

He said: "We have got to do it because of the credit markets and the bond markets and our credit ratings and if any so-called sources from the Treasury undermine our credit ratings by such briefings they ought to be ashamed of themselves."

Mr Osborne said: "If Gordon Brown has overruled the advice of the Treasury in order to put his own political interests ahead of the economic interests of the nation, he has betrayed the responsibilities of the office he holds."

The Ministry of Defence will next week announce the closure of an RAF base and cuts in the military presence because of a cash squeeze, Channel 4 News reported last night. IT, human resources and back-office functions will also be affected because of a £6bn overspend, mainly on procuring aircraft, submarines and ships. A senior MoD official told the programme the department was in "real financial trouble".