Alistair Darling has announced a 2.5 per cent reduction in VAT, to be paid for by deferred tax rises, in his pre-Budget report.

The chancellor on Monday set out plans to cut the 17.5 per cent of value added tax on goods and services to 15 per cent for 13 months.

However in a radical shift for the Labour Party, which has previously pledged not to raise the basic or top rate of income tax, he also confirmed that the government would introduce a new 45 per cent rate for earnings over £150,000, if the government were re-elected for a fourth term.

The policy is part of a package of medium-term measures designed to recoup cash from the Treasury's short-term fiscal stimulus and bring the public finances back into balance in the face of record deficits.

The VAT move, which would cost £12.5bn, is intended to boost consumer spending and stimulate the economy.

It would take VAT to the lowest level allowed under EU law, representing the first time change in the tax since the Conservatives increased it to 17.5 per cent in the early 1990s.

Darling said that the statement was being "made against a background of economic uncertainty not seen for generations".

"These are extraordinary, challenging times for the global economy," he told MPs.

"And they are having an impact on businesses and families right across the world."

Aims

And he said his aim was "to provide support and protection for families and businesses when they need it most".

"To maintain our commitment to investing in schools, hospitals and the nation's key infrastructure," he went on.

"And to put in place the measures necessary to ensure sound public finances in the medium term so that as a country we live within our means.

"Not one single initiative, but a comprehensive plan, to support families, business and the economy.

"And because of the wide ranging measures I am announcing today and the many strengths of the British economy, I am confident that the slowdown will be shallower and shorter than would have been the case.

"I am also confident that the UK, as an adaptable and open economy, will be well positioned to benefit from a return to growth in the world economy."

In order to kick-start the economy out of recession, Darling announced he was "bringing forward capital spending to support jobs and businesses".

Up to £3bn for schemes including motorways, school building and home insulation will be brought forward from 2010/11 to this year and 2009.

The chancellor said the spending "will help put money into the economy in the coming months".

The state pension will also increase in line with the highest rate of inflation and an increase in child benefit will be brought forward from April 2009 to January.

And there will be a one-off payment for pensioners of £60 in January next year on top of the increased winter fuel allowance.

Tax cuts

Confirming a widely-expected cut in VAT from 17.5 to 15 per cent, Darling said his "substantial fiscal loosening", worth £20bn in total, would include help for "millions of households who pay no direct tax at all".

The cut in prices will come into effect from next Monday, December 1, and apply for 13 months until December 31, 2009, when the government expects the economy will have begun to recover.

In additional tax measures the chancellor pledged to help people on "modest, low and middle incomes".

The compensation for the abolition of the 10p income tax rate is to be made permanent and increased from £120 too £140 per year from April 2009.

Increases in child tax credit will also be brought forward, while planned increases in vehicle excise duty on higher-polluting cars will instead be phased in more slowly and at a lower rate.

Tax rises

But the chancellor also pledged future tax rises as part of a bid to return to "sustainable public finances in the medium term".

He said that with the tax burden as a share of GDP set to fall in the next few years, there was scope for some increase as the economy improves.

Therefore from April 2011 national insurance payments for employers and employees will be increased by 0.5 per cent, although in compensation the starting point for payments will be raised to align it with income tax.

As expected, there will also be a new 45 per cent rate of income tax on earnings over £150,000, affecting the top one per cent of incomes from April 2011.

Duties on alcohol, cigarettes and petrol will also be increased to offset the VAT reduction on these products.

Business

Turning to help for small business, the chancellor announced a temporary increase in the threshold for empty property relief for commercial properties worth up to £15,000.

In other measures HM Revenue and Customs will also enable firms to spread their tax payments to "a timetable they can afford" immediately.

Darling said his would be a "real help when businesses need it most".

He pledged to take "whatever action is necessary to make sure" banks lend to small firms and pass on cuts in interest rates, holding out the threat of legislation.

He also pledged £1bn in a new government-backed small business finance scheme and £1bn more support for exporters through the Export Credit Guarantee Department.

And he said he would defer an increase in small firms' corporation tax and unveiled an ability to offset tax liabilities for businesses against previous losses.

'Choice'

Darling concluded that the government was taking "action now to help people - and action now to build a stable economy".

"We have made our choice," he said. "Helping businesses. Helping homeowners. Helping people into work. Boosting incomes.

"All only possible because this government has taken the deliberate decision to support people and businesses through these difficult times."

However shadow chancellor George Osborne said the immediate £20bn tax cuts and spending increases would be followed by £40bn of tax rises after the next general election, following a "political" timetable rather than the economic cycle.