Clarke steps into the war zone: Whitehall's spending battle is the first test for the Chancellor. Robert Chote reports

KENNETH CLARKE'S appointment as Chancellor of the Exchequer comes during one of the unchanging rituals of the Whitehall year: the guerrilla war of leaks and rumours over public spending between the Treasury and other government departments.

For weeks, details of possible cuts have been filtering out of the spending departments, which hope that an outcry will deflect the axe elsewhere. 'The battle between the Treasury and spending departments is perennial,' says Professor Andrew Likierman, of the London Business School. 'Every Cabinet minister wants to cut the size of the cake, but no one wants it to be their slice that suffers.'

Mr Clarke can stamp his authority on this unseemly process later this month, when the Cabinet sets spending ceilings for the next three financial years. Will he stick by the totals his predecessor announced in the autumn, or will he succeed in imposing a further tightening of the belt? The outcome will show us how far Mr Clarke's arrival has shifted the balance of power between the Treasury and the Prime Minister's office.

Before Norman Lamont's departure, senior Treasury advisers conceded they were losing a series of battles with John Major. The authority of the Treasury and the Chancellor had been so damaged by the debacle of Black Wednesday that they expected Mr Major to veto most cuts they came up with.

But even Mr Lamont's most loyal supporters believe Mr Clarke's arrival may herald a change. 'At least we now have a Chancellor with serious political clout. We may end up with a government which is more Treasury dominated,' one official said.

The need for action is clear. The Government expects to spend about pounds 286bn this financial year, including pounds 19.5bn of debt interest. This outstrips the amount of taxes it expects to raise by about pounds 50bn.

Economic recovery will relieve some of the pain automatically. Tax revenues will grow as incomes, profits and spending revive, while fewer people will claim unemployment and other benefits as the jobless total falls. But perhaps half the shortfall between spending and tax revenue will not disappear as the economy recovers, and needs to be tackled directly.

The spending departments have received due warning. Each secretary of state has had to submit a 'position paper' to Michael Portillo, Chief Secretary to the Treasury. This assesses the implications of sticking to the limits set in the Autumn Statement, and makes the case for any increases. The 'new control total' for the bulk of government spending has been set at pounds 253.6bn for 1994/5, which excludes pounds 16bn of unavoidable social security spending and pounds 23.5bn of debt interest.

The departments have also been asked to illustrate how they would make cuts of 2.5 and 5 per cent in their budgets. It is some of these illustrative proposals that have been leaked, as the departments try to frighten Mr Major away from those that affect them. Local authorities have also been asked how they would make 2 per cent efficiency savings.

About a quarter of public expenditure is carried out by local authorities, an estimated pounds 69.8bn in 1992/3. About two-thirds is financed by central government grants and business rates, which are set by Whitehall. A sixth is financed by the community charge, with the remainder coming from rents, borrowing and fees.

Total local authority spending is tightly controlled by central government. Whitehall has to approve councils' borrowing and is able to cap their spending if it rises too far above the level it believes is needed to provide adequate local services.

Several departments have demanded more money than they were allocated in the Autumn Statement, although the overshoot is less than the pounds 14bn of extra bids submitted this time last year, before the new top- down spending regime came in.

As the graphic shows, government spending is expected to account for more than 45 per cent of all goods and services produced in the economy through the year, the highest share since 1985/6. Mr Portillo hopes to bring the figure closer to 40 per cent, which will demand further cuts.

Messrs Portillo and Clarke will have to concentrate their efforts on the departments with the largest budgets, which is why health, education, the Home Office and social security are already coming under special scrutiny in a rolling review of spending.

Among the mooted cuts to the health budget are subsidised prescriptions for children and better-off pensioners, charges for hospital accommodation, removing dentistry from the NHS and a cap on GPs' drug bills. Money could also be raised by charging well-off parents for their children's tuition fees in higher education. The Home Office may be asked to save money on running the courts.

On economic grounds, there is a good case for many of these cuts. A recent study by the Institute for Fiscal Studies showed that middle-earners were gaining more than the poor from welfare state 'benefits in kind'. Unfortunately, many such recipients are natural Conservative voters.

Savings suggested in other departments include ending the payment of mortgage interest for people made redundant, reducing council house rent subsidies, slowing the road-building programme and spending less on new defence equipment. About pounds 23.8bn was spent on defence in 1992/3, with the Autumn Statement proposing cuts of 10 per cent in real terms over three years. But a further review ahead of next month's White Paper on defence has identified larger possible savings, cutting equipment and manpower.

Restraining public sector pay is seen as another important way to keep spending down, although the Treasury believes it would be difficult to enforce the 1.5 per cent ceiling for a second successive year. Public sector pay accounted for nearly 30 per cent of government spending in 1991/2.

But advocates of spending cuts inside and outside the Treasury agree that tackling the social security budget is the key to success; Mr Portillo has called its growth a 'cuckoo in the nest'. Social security accounted for pounds 80bn of public spending in 1992/3, about a third of the total and much more than the revenue from income tax and corporation tax combined.

Rising unemployment has pushed social security spending up, but falls in the dole queue are not expected to produce equivalent savings. One reason is that middle-aged people made redundant are claiming invalidity benefit. Direct savings in unemployment benefit itself are difficult to achieve as fraudsters are expensive to catch and 'workfare' is more expensive than the current system.

Public spending cuts are never popular. They will only be achieved if Mr Major and Mr Clarke are convinced that the alternative - tax increases - is even less attractive.

(Charts omitted)