Bill Jamieson - Troubles heading from High Street to Downing Street

REPORTS of a morale meltdown at the Treasury, with mounting worries over the state of the public finances, completed a week of utter misery for Chancellor Alistair Darling.

The problems he faces are far greater than the prospect of the National Audit Office declining to 'sign off' the accounts due to be published before the parliamentary recess in three weeks' time. A yawning gap is now opening up between forecasts of tax revenues and the likely reality over this fiscal year and next.

A second related concern is the effect that a crisis in the public finances this autumn would have on the pound. Any sharp weakening of sterling would drive up import bills and heighten the inflation threat, forcing the Bank of England to put up interest rates. The Government sector may soon be facing a severe credit crunch of its own as the Government wrestles to prevent borrowing from billowing out of control. Faced with an unravelling of tax and spending plans and further u-turns on tax through interference from the Prime Minister on 'green' taxes, is the Chancellor's position tenable for much longer?

The tumultuous effects of the unravelling credit crunch have torn through the banking system, the housing market and – most visibly last week – the retail sector, with shocking figures from Marks & Spencer and John Lewis.

But the storm has yet to hit the Government sector. Public spending continues to rise. Here in Scotland there were loud protestations in the spring of a "tight" spending settlement with growth in "real terms" of public spending kept within a ceiling of 1% over this year and next. That, in retrospect, is now coming to look like the lap of luxury. Tax revenues are set to fall significantly short of forecast over the next two years, forcing the Treasury either to let borrowing rip or to pare back on spending plans.

That, in the short term, does not alleviate recession fears, but worsens them. It is the relatively high level of Government spend to GDP in Scotland, and the large numbers employed in the public sector – some 20% of total employment – that have helped insulate the economy here from the full force of the downward blast.

The Chancellor forecast in the budget that the economy is going to grow by between 1.75% and 2.25% this year and recover to higher growth of between 2% and 2.5% in 2009. Both forecasts have now been left behind as independent economists slash their forecasts by the month. Almost all agree that 2009 is going to see a further slowdown, not growth.

Government borrowing is the residual item between two huge totals that are strongly influenced by the rate of growth in the wider economy: Government revenues and Government spending. As such, the borrowing requirement is notoriously difficult to predict, even in 'normal' economic conditions. What tends to happen in downturns is that tax revenues fall, reflecting lower numbers in work (depressing income tax receipts) and a downturn in spending (which affects VAT receipts). At the same time demands on Government welfare spending rise as unemployment climbs and households, unable to keep up mortgage payments, turn to the Government for help.

In Alistair Darling's budget earlier this year, Government revenue – the vast bulk of it from tax receipts – was expected to rise in the current financial year from £550bn to £575bn, increasing to £608bn in 2009-10. Government spending was forecast to rise from £540bn in 2007-08 to £566bn in 2008-09 and to £592bn in 2009-10. Net borrowing after various adjustments was forecast to rise from £36.4bn to £43bn, falling back to £38bn in 2009-10.

Three months into this 'credit crunch' financial year, one conclusion can safely be drawn: all the above figures will be wrong.

Of the revenue total, some £517bn comes from taxes and National Insurance contributions. The Chancellor is counting on income tax receipts rising from £156bn in 2007-08 to £160bn this year. But as unemployment rises, this is unlikely to be met. VAT receipts are projected to bring in an extra £3.3bn at £83.8bn. But the news from the high street suggests a big pull-back by consumers.

Then there is Stamp Duty, where the Treasury has already allowed for a fall, from £14bn to £13.5bn. But such is the slump in housing transactions it is difficult to see how even this lower figure will be met. Other vulnerable tax receipts such as Corporation Tax (forecast to rise from £47bn to £51.9bn) business rates and Capital Gains Tax also look vulnerable.

Thus, even allowing for a sharp rise in receipts from Petroleum Revenue Tax (£1.7bn) and fuel duties (£25.7bn), the 'oil gush' effect is unlikely to plug the gap created by shrinking tax revenues elsewhere.

Given that the budget deficit is now right up to its ceiling of 3% of GDP, how can the Treasury avoid breaking this 'golden rule' without a sharp reduction in Government spending plans? And should a Chancellor be cutting Government spending when the orthodox Keynesian solution to a downturn demands big spending on public infrastructure projects?

The harsh truth is that Darling – or his successor – is going to have to take the axe to the Government sector payroll and bite the bullet on such issues as inflation-proofed pensions for civil servants. Voters will not be at all happy if the impression gains ground that everyone in the private sector is expected to take a hit while the millions employed in public administration continue with pay and privileges unscathed. And as the economy slows further, the contrast between private pain and public profligacy is set to grow even more stark.

However, the sanction of the voters is the least of the Treasury's problems. An economy such as the UK, with the highest ratio of personal indebtedness to GDP in the OECD, is going to be hit hard as the global de-leveraging strikes home. Sterling is already vulnerable. But the prospect of a billowing budget deficit and rise in overall Government debt is set, on past form, to send the currency into a tailspin.

A collapse in the pound will be a boon, of course, to exporters. But in the meantime it threatens real grief for the Bank of England obliged to keep Consumer Price Inflation down at 2%.

A slowing economy, a housing slump, the banks caught in a credit crunch and the public finances unravelling: little wonder morale at the Treasury is said to be sinking. For the moment the public sector looks a safe haven as the problems mount all around. It may not be safe for long.