Debt-laden U.K. to cut budget drastically

NEW YORK (CNNMoney.com) -- No one will be spared, not even the Queen.

Britain's coalition government on Tuesday put out the country's harshest budget in decades. The plan makes clear that Britain is dead serious about attacking the country's debt burden, which is among the largest and fastest-growing in Europe.

So serious, in fact, that a higher capital gains tax rate will take effect at midnight for high-income taxpayers.

The five-year budget, widely anticipated by fiscal experts, may hold lessons for U.S. policymakers who will face similar quandaries about how to rein in debt.

"The types of policy changes there are certainly a more realistic insight into what we will have to contemplate than talk of earmark reform and incremental changes we are still focusing on here," said Maya MacGuineas, president of the bipartisan Committee for a Responsible Federal Budget.

U.K. Chancellor George Osborne told Parliament that the overarching goal is to eliminate major parts of the annual deficits by 2015, and to ensure that the country's debt will begin to fall as a percentage of GDP.

Britain's debt, which tops $1 trillion, is on pace to double in the next five years. Interest payments on that debt, already high, are set to climb by an estimated 67% during that period. Meanwhile, its annual deficit reached 11% of GDP last year and is on track to hit 10.5% this year.

The budget comes at a time when policymakers in Washington and in Europe are debating when to make the switch from nursing economic recovery to embarking on fiscal discipline. Critics of immediate fiscal austerity warn that it would snuff out still-fragile economic growth.

Osborne doesn't buy it.

"Some have suggested that there is a choice between dealing with our debts and going for growth. That is a false choice. The crisis in the Eurozone shows that unless we deal with our debts there will be no growth," Osborne told the Parliament.

The path the coalition government has set up is stringent to say the least.

Osborne said 77% of the consolidation called for will come from spending cuts and 23% by way of increased tax revenue.

Spending in the public sector, which has continued to grow even as the private sector has shrank, will be reined in.

"I know there are many dedicated public sector workers who work very hard and did not cause this recession -- but they must share the burden as we pay to clean it up," Osborne said. "The truth is that the country was living beyond its means when the recession came. And if we don't tackle pay and pensions, more jobs will be lost."

He proposed a two-year freeze on public-sector pay for all but the lowest income workers. He also proposed capping the pay of those who run public sector organizations so that it doesn't exceed 20 times that of the lowest paid worker.

The government is also analyzing how best to control costs in state pensions.

In terms of targets for national agencies, the government is aiming to cut spending by 25% by 2014. But the National Health Service will be protected, and cuts in education and defense are not likely to be as harsh as they are for other areas.

Social welfare benefits -- such as those for the unemployed, disabled and pregnant -- will reduced or eliminated for some people.

Osborne also said Queen Elizabeth's budget will be frozen at the same level where it's been for the past 20 years, and her future expenditures to carry out her duties will be subject to audit.

The budget proposes several tax increases. These include the capital gains tax, currently 18%, which will rise to 28% for high-income taxpayers. The value-added tax will increase from 17.5% to 20%. And banks will be subject to a new tax. In addition, a financial transactions tax is under consideration.

The value of several tax credits -- both for individuals and business -- will be limited.

But not all of Osborne's plan is austere. In order to attract business to Britain, for example, he said the corporate tax rate will be cut as will small business tax rates. In addition, almost 900,000 low-income people will no longer owe any income tax.

And to the relief of English football fanatics, the coalition government will reverse a planned increase this month in the duty on cider "just in time to celebrate England's progress to the quarter finals, or else to drown our sorrows," Osborne said.

A lot is riding on the reception of the budget in the markets. While Britain maintains a sterling AAA credit rating, Standard & Poor's in May 2009 lowered its credit outlook on U.K. debt to "negative" from "stable." And the agency said it would revisit its decision after the release of the new government's budget.

"Questions that were asked about the liquidity and solvency of banking systems are now being asked of the liquidity and solvency of some of the governments that stand behind those banks," Osborne said. "I do not want those questions ever to be asked of this country."

The U.K.'s bold move to start its deficit-cutting regime this year seems to be exactly the kind of immediate belt-tightening that President Obama cautioned against in a letter to leaders of the G20, who will meet in Toronto this weekend.

While acknowledging the need for G20 countries to commit to stabilizing their debt-to-GDP ratios in the medium term, the president said pulling in the reins on spending too soon could hurt the nascent economic recovery.

"We must be flexible in adjusting the pace of consolidation and learn from the consequential mistakes of the past when stimulus was too quickly withdrawn and resulted in renewed economic hardships and recession," Obama wrote.

The country's new Office for Budget Responsibility estimates that under the new budget annual real GDP growth in Britain will average 2.4% over the next five years.

Should the economy underperform relative to those projections, all bets are off politically. "The huge risk for the government is on the growth side," said Wolfango Piccoli, an analyst at the Eurasia Group. "They took a significant bet."

Whether fiscal tightening in Britain derails the country's recovery depends on the state of the global economy, said IHS Global Insight chief UK economist Howard Archer in a research note. The stronger it is, the more likely it is that the U.K. recovery will withstand fiscal austerity.

But, Archer noted, "if the global economy suffers serious problems ... particularly related to events in the Eurozone, then the U.K. economy could struggle terribly."