Threat of 3p tax increase

Tax hikes of up to £10 billion were forecast by the City today after a shock rise in public sector borrowing.

This would be equivalent to putting almost 3p on the basic rate of income tax.

Gordon Brown's Budget predictions were knocked sideways by the worst official monthly figures for borrowing since records began in 1993. Coming just six weeks after the general election, the gloomy news hung a question-mark over the Chancellor's assurances that taxes would not need to rise at all to pay for Labour's spending promises.

Net government borrowing hit £8.7 billion in May - a sharp £1.7 billion increase on the year before. This followed a sharp rise in state spending for the month, especially on education.

The Treasury said this had caused only a temporary upward blip. But independent economists were unnerved by a figure they described as as far above expectations.

Jonathan Loynes, chief UK economist at Capital Economics, said he expects borrowing to overshoot Mr Brown's ?32 billion Budget forecast by at least £2 billion, forcing the Chancellor to find around ?10 billion more in taxes in his 2006 Budget.

He added: "May's figures might prove to be a blip in an otherwise improving trend. But we have been warning that the improvement was unlikely to be sustained against a background of slowing economic growth."

Alan Clarke, of BNP Paribas, said Mr Brown had "a bit of a mountain to climb" to get back on track. Howard Archer, chief UK economist at Global Insight, said it looked increasingly unlikely that the Chancellor could meet his so-called "golden rule", which says borrowing should be used for investment rather than daily bills over a full economic cycle.

He said "significant corrective action seems inevitable in next year's Budget."

The borrowing surge coincided with a 1.8 per cent fall in VAT receipts, seen by many as a sign of waning activity in the high street.

If the trend continues Mr Brown will face a difficult dilemma in his next Budget, choosing whether to raise borrowing further - and be accused of breaking his fiscal rules - or raise taxes and be accused of misleading voters.

At the height of the election campaign, the Chancellor repeatedly dismissed predictions of massive tax rises if Labour won a third term. On 11 April, he said: "Every single item of expenditure is costed in our spending plans."

Tony Blair assured voters that current tax levels were "sufficient" for the Government's "forward plans".

If the worst fears are now realised, the Chancellor might now have to resort to direct taxes like National Insurance or income tax.

But Mr Brown's senior aides say the City is making too much of a single month's figures and predicted the rest of the year would prove the official forecasts were spot-on.

"The Treasury has a rather better record in forecasting than the City," said one aide.