Alistair Darling faces a very tough job in drawing up his March Budget. Just how tough is shown by the annual Green Budget produced by the Institute for Fiscal Studies in collaboration with Morgan Stanley, a “must read” for everyone in the political world.

The implications are likely to matter far more for the timing and outcome of the next election than the recent rows over political funding and Europe.

The economic outlook for the next few years is worse than for some time and Mr Darling has no freedom for manoeuvre on taxes and spending. Not only is there no room for preelection giveaways, but spending plans are insufficient to achieve existing goals on health, education and reducing child poverty.

The Government blames international factors, notably the sub-prime banking crisis in the US. At the same time, ministers highlight low levels of inflation and of interest rates compared with the early 1990s. Both points are true up to a point but, as the Green Budget shows, the deteriorating fiscal position is largely home grown.

Looking back to 1997, Labour has succeeded in reducing both the structural budget deficit and the overall debt burden below inherited levels but a large majority of other industrialised countries have done more to cut both.

In particular, fiscal policy was not nearly tight enough during the good years. A partial adjustment is now occurring to improve public finances with plans to raise the tax burden to a 24-year high and to reduce the share of spending to an 8-year low. As the IFS puts it, half the proceeds of growth will be taken by taxes.

A further big adjustment is now needed, however, to get the public finances and borrowing back on course for the Treasury’s self-imposed and widely discredited “golden rule” ceiling for public sector debt.

This is because the IFS is gloomier than the Treasury about the outlook for tax receipts and borrowing. Hence, the headlines about the need for £8 billion of tax increases. (This is quite separate from the rescue of Northern Rock, where the eventual cost to taxpayers will depend on the sale of its mortgage book.) There is, as the Green Budget concedes, little chance of this happening because of the Government’s current political difficulties.

The report speculates that Mr Darling will argue that further bad news on public finances is only temporary, and it would be a mistake to tighten fiscal policy when the downside risks to the economy are so great.

The scope to cut interest rates may be constrained in the short term by higher-than-desired inflation this year.

Yet even if fiscal policy is not tightened this year, action will still have to be taken at some stage to bring the public finances back on track. The sooner this adjustment is made, the more scope there will be to loosen monetary policy through lower interest rates. So the Government looks boxed in. The electoral consequences are complicated.

What matters is not just the state of the economy, but more whether the Government is seen as competent in managing the economy. Labour is already losing its edge here to the Tories. The good years so far this decade may be gone, not only economically but also politically.

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