Clegg's hope of tax cut for poor hit by bleak news on economy

Credit rating alert and rise in jobless figures may force the Chancellor to rule out move

Nick Clegg's hopes of faster tax cuts for low earners have been hit by the succession of grim news in the economy.

Britain's cherished AAA credit rating is under renewed pressure because of fears over weaker-than-expected growth figures and the impact of the eurozone crisis on this country.

The threat of downgrading was raised as senior Coalition figures debated in detail the contents of George Osborne's Budget next month. The growing pessimism – ahead of figures today expected to show a further rise in unemployment – is restricting room for manoeuvre. Mr Clegg has been openly urging the Chancellor to introduce a £10,000 personal income tax allowance more quickly than had been planned in order to ease the pressure on family budgets.

The first increase in the allowance, from £6,475 to £7,475, was announced in the 2010 Budget and is set to rise again to £8,105 in April. Mr Clegg had been pushing for an announcement of a further steep increase to take effect next year. But as Mr Osborne yesterday reiterated his determination to bear down on public spending, the Deputy Prime Minister's chances of winning his public battle are in jeopardy.

Tory sources doubt the move can be seen as a priority when there is so little flexibility in public finances. Moving to the £10,000 threshold in 2014 would cost an estimated £5.5bn.

In addition, the fall in inflation would make it more expensive to push up the income tax threshold by more than the cost of living. The Liberal Democrats want an end to higher rate income tax relief on the pensions of middle and top earners. One alternative being discussed is to retain the 40 per cent tax relief rate while limiting the cash that can be put into a saving scheme in any year. The cap is currently £50,000, well beyond the limit of all but the wealthiest.

Mr Osborne defended his austerity package yesterday after the rating agency Moody's put the UK on "negative outlook". He said: "Here is yet another organisation warning Britain that if we spend or borrow too much we are going to lose our credit rating."

But Ed Balls, the shadow Chancellor, said: "With our economy now in reverse, unemployment at a 17-year high and £158bn extra borrowing to pay for economic failure, the case for a change of course and a real plan for jobs and growth is growing by the day."

Financial markets shrugged off the Moody's warning. British 10-year bond yields fell over the day, ending at around 2.1 per cent. Some economists argue the impact of any downgrade would be minimal. The US was downgraded last August by Standard & Poor's and subsequently saw long-term borrowing costs fall. Japan was downgraded by Moody's in 1998 but now has 10-year borrowing costs of less than 1 per cent.

Jonathan Portes, head of the National Institute of Economic and Social Research, said the Treasury's stance should be: "We couldn't care less what rating agencies say. The UK will pay its debts."

The rating game: What the letters mean

Aaa

The gold standard of Moody's credit ratings hierarchy. The UK and France are in danger of losing it. But Germany and Switzerland are safe.

Aa

Very low credit risk, according to Moody's. China and Saudi Arabia.

A

Low but not entirely negligible danger of default. Spain and Italy.

Baa

May contain certain "speculative characteristics". In other words, people who are willing to take a bit of risk in return for a higher return might consider it. Mexico, Brazil, India.

B

"Substantial credit risk". In other words, buyer beware. Mongolia, Pakistan and Egypt.

Caa

"Poor standing and high credit risk". Only professional investors should think about going near this. Cuba.

Ca

"Likely in, or very near, default, but with some prospect of recovery of principal and interest". You might get a bit of money back if you're lucky. Greece.

C

Toxic waste. Investors are not even likely to get the principal on their investment back. No states are rated this low at the moment.