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UK Prepares deep cutsLONDON—The U.K.'s new coalition government will deliver Britain's most important and painful budget in decades on Tuesday, with a spending plan that is likely to define the fortunes of both the government and the country for years to come.
Faced with one of the highest budget deficits in the world in terms of percentage of gross domestic product, Treasury chief George Osborne has warned of steep spending cuts and tax increases that economists say could ultimately be the equivalent of as much as 8% of GDP over the next five years, the sharpest pace of fiscal belt-tightening in the U.K.'s postwar history.
The government's program of dramatic cuts will put the U.K. on a different track from the one suggested by President Barack Obama, who has called for large economies to tread carefully and not risk the fragile global recovery.
The government knows that its credibility in financial markets and its triple-A credit rating are at stake at a time when countries across Europe are under severe scrutiny. Such tough fiscal medicine will set it up for a clash with unions and state workers, in a country where almost half the jobs depend directly or indirectly on the government.
"This budget's significance is immense, you have to maintain your triple-A rating," said Stuart Thomson, a government-debt investor at Ignis Asset Management. But, he said, "George Osborne George Osbornefaces a danger, caught between not cutting enough for the markets and cutting too much for the long-term health of the economy."
The government has already said it will take measures such as levying some kind of tax on banks, changing the structure of taxes on the airline industry to raise more revenue, and increasing the capital-gains tax to nearer the 50% highest income-tax level. Economists also expect it to raise the value added tax to 20% from 17.5% and expect news of aggressive cuts on the country's welfare and state pensions bill.
As it raises taxes elsewhere, the government also will exempt around 880,000 of the lowest-paid U.K. residents from having to pay income taxes while increasing the number of people—by some 650,000—for whom employers don't have to pay payroll taxes, according to a person familiar with the matter.
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That reflects pressure on the government to not be seen as too hard on the poorest. It is also a nod to the coalition agreement Prime Minister David Cameron's Conservative Party accepted with the more left-leaning manifesto of its governing partner, the Liberal Democrats.
The government will pledge not to make further cuts to government capital spending, such as infrastructure projects, this person said, amid concern from businesses that this could undermine the productive capacity of the economy.
Governments around the world are faced with the same dilemma. As some announce aggressive cuts, others are pressured into following suit by the markets. But such measures add to governments withdrawing demand from the global economy.
On Friday, Mr. Obama wrote to the Group of 20 leading nations with a clear warning against cutting deficits too quickly. He suggested that G-20 countries are ready to respond with pro-growth measures if the global economy starts to slide again.
Some countries have already complained, for example, that the German government's fiscal squeeze will hurt Europe's ability to bounce back. Germany has said it will shave €80 billion ($99 billion) off its deficit between 2011 and 2014, or around 3.3% of GDP, with cuts of around €10 billion in 2011.
Among large economies, the U.K.'s cuts are expected to be among the biggest. Its structural deficit—the gap in the government's finances that won't be erased by an uptick in growth—is estimated at almost 9%, compared with 5% in the European Union, 7% in Japan and 7% in the U.S. But few other big economies are faced with ratings agencies making market-moving calls for greater details of cuts. At the other end of the scale, embattled Greece has been forced to promise cuts to its deficit by 11% of GDP by 2013, and the U.K.'s growth and lending predictions are considerably rosier than Greece's.
In cutting so deeply, some economists and the Labour opposition worry that the U.K. may hurt its economic comeback.
Ross Walker, an economist at Royal Bank of Scotland, expects as a result of the cuts that the Office for Budget Responsibility's growth forecasts will be as much as 0.25 percentage point lower a year and the jobless rate will be lifted by 0.25 percentage point annually for 2010 through 2012. For many, that is a price worth paying. In addition to the market demands for more fiscal responsibility, the U.K.'s annual debt-interest bill jumped by 45% to £4.34 billion ($6.43 billion) in May 2010, and the government expects it to hit £70 billion by 2015—more than the combined education, transport and climate-change budgets, and almost twice the annual revenue from taxes on company profits.
—Laurence Norman in London and Marcus Walker in Berlin contributed to this article.— Write to Alistair MacDonald at alistair.macdonald@wsj.com
