George Osborne, Britain's Chancellor of the Exchequer, will announce plans for the biggest assault on welfare benefits in Wednesday's emergency budget as part of an estimated £85 billion ($178 billion) package of savings and tax rises to reduce the country's record peacetime deficit.

The Chancellor believes by slashing the £180 billion-a-year welfare bill, he can help protect spending in other areas, such as education, defence and transport, as well as safeguarding capital projects vital to the economy.

"If we drive down the welfare bill, that allows more money to be allocated to departments," a government source said.

The focus on welfare and benefit reform is likely to include cuts in tax credits for wealthier families, and could see the end of child benefit payment to higher earners. It will also put Osborne on a collision course with unions, which fear the poor will be hit hardest.

But the coalition Government hopes to soften the impact of deep reductions in public spending - and deflect criticism from those who say the cuts will put economic recovery at risk - by presenting a parallel growth strategy for the public sector, based on safeguarding infrastructure projects, education reform and tax incentives for business.

Government sources said Osborne would set an overall figure for reining in public expenditure over the next five years as he seeks to eliminate the structural deficit.

Estimates by the Institute for Fiscal Studies suggest £85 billion will have to be found in cuts and tax rises over the course of this Parliament to balance the books.

But budgets for individual departments will only be revealed in the northern autumn, when it is known how much can be trimmed from welfare spending after a "no-holds-barred" review.

A report by the think-tank Reform, which is close to the Conservatives, called for a curb on "middle-class welfare". It proposed reducing spending on child benefit, child tax credit, the winter fuel allowance for pensioners and more. Overall, it called for a £13 billion reduction in state benefits.

The Policy Exchange, another think-tank close to the Tories, claimed billions paid by better-off families in taxation is handed straight back to them in benefits. It found that last year £53.5 billion - 32 per cent of all benefits - were paid to families with a higher than average income.

Osborne will also announce plans for a levy on banks, and pave the way for tight limits on the pay and pensions of six million public sector workers.

However, with Britain still in the early stages of recovery from its deepest and longest postwar recession, Osborne may delay big tax and spending changes - including a rise in VAT (sales tax) - until next year, in the hope growth will by then be more firmly established.

Former Labour chancellor Alistair Darling argues: "The Chancellor's proposal of quicker and bigger reductions in government borrowing rests on the belief that, if the public sector comes down, the private sector automatically rises - the seesaw. If government spending falls faster, the private sector grows more quickly to fill the gap. But in times like these, this is just wrong. It is not inevitable that the private sector steps in when government cuts back."

The budget will offer new firms in rundown regions a £900 million tax break to hire workers as the Government seeks to boost private sector job creation.

Any company set up outside London, the south-east and the eastern regions will not have to pay employer national insurance contributions for its first year in business.

Mark Serwotka, general secretary of the Public and Commercial Services Union, said he would resist benefit cuts. "It is a disgrace that the coalition Government plans to target low-paid public sector workers and those receiving welfare benefits in its emergency budget."

Tomorrow, the Transport Secretary, Philip Hammond, will launch the sale of rights to run the former Channel Tunnel Rail Link, operated by the government-owned London and Continental Railways. Ministers are hoping to raise more than the £1.5 billion.

Free market think-tanks and business groups are urging Osborne to use the budget to get serious about reform. The Adam Smith Institute, the Institute of Economic Affairs (IEA), Reform, Policy Exchange and the Confederation of British Industry (CBI) believe the new chancellor has the opportunity to do what Margaret Thatcher never managed - downsize the state.

Such an agenda seemed improbable a year ago when it was the willingness of governments to spend and borrow freely that prevented recession from turning into slump. Then, the order of business was first to kick-start growth and then to sort out the systemic problems of big finance. Cutting budget deficits was a residual issue.

But the idea of shrinking the state has become a hot topic, on the fringes of Westminster if not at the heart of government.

The fact that Labour, had it won the election, would have imposed cuts described by Darling as "tougher than Thatcher" has meant it has become possible to "think the unthinkable".

Mark Littlewood, director of the IEA, believes the £150 billion hole in the government's finances presents the government with a golden opportunity to reduce the size of state spending from 48 per cent to nearer 30 per cent.

Over the past three decades, public spending has tended to oscillate either side of 40 per cent of GDP: the free-marketeers would like to see it move closer to US levels.

"We are trying to ensure that necessity is the mother of invention, in that the deficit spurs the coalition to take a broader view of what the public sector should be doing. The star chamber to assess departmental spending is a start, but it needs to go further," Littlewood, a former adviser to the Liberal Democrats, says.

He is concerned the coalition may simply focus on "salami-slicing", with the result that the state does pretty much what it did before but with less money.

Instead, he wants the Department of Culture, Media and Sport, and Business, Innovation and Skills department scrapped. The IEA also has universal child benefit, winter fuel allowances and free bus passes in its sights.

The Policy Exchange says middle-income households are paying tax and then being "given their own money back, minus huge administration costs".

It also says that 43 per cent of Child Benefit (£4.8 billion) goes to those on above-average incomes, and 40 per cent of Disability Living Allowance (£4.2 billion).

Around £3 billion of the £23 billion tax credit bill is paid to above-average-income households.

But does the coalition have a mandate for radical cuts? The TUC argues a pre-election pledge to tackle inefficiency in Whitehall and scrap a few quangos has morphed into a wholesale attack on the state. The union body's chief economist, Adam Lent, likens this volte-face to the previous government's policy on Iraq.

"We can see the tabloid press is goading the Tory-led government to take a tougher line and deliver Thatcherism Mark II. Yet as with the Iraq war, it is a false prospectus - there is no basis, other than ideology, for attacking the state and nobody voted for it," he says.

Littlewood concedes the government failed to gain a mandate to follow his agenda for radical downsizing. "We warned during the election that selling the idea of efficiency savings and promising to protect frontline services would box them in. So, there is no mandate for radical surgery," he says.

The Prime Minister, David Cameron, deliberately ringfenced two areas of spending - health and international development - in the election campaign to try to rid the Conservatives of their "nasty party" image.

Seeking to occupy the political centre ground sits uneasily with privatising chunks of the welfare state to pay for lower taxes.

Policy Exchange chief economist Andrew Lilico professes dismay at the coalition's reticence. He wants the government to recognise that demands on Britain's public finances will only increase, and that government must consider things that were "previously unsayable and possibly unthinkable".

Under the knife
* Vat
Many analysts predict an increase in the tax on consumer spending from 17.5 per cent, with the figure of 20 per cent the most widely predicted, netting around £12 billion in revenue.

* Green taxes
In a concession to Liberal Democrats, the system for taxing flights will change - inevitably increasing the cost of flying. For environmentalists, this is a welcome balancing of the tax burden. The air passenger duty, levied on individuals, will be replaced by an aviation tax per plane - to discourage airlines from flying planes that are half full.

* Bank taxes
Such taxes are likely to be high on the agenda at next week's G20 summit in Canada. Civil servants have been examining a combination of bank taxes, including an annual levy on profits, worth up to £8 billion.

* Income tax/national insurance
A key part of the coalition deal was the adoption of the flagship Lib Dem manifesto pledge for the poorest to pay less income tax. The Lib Dems wanted to raise the starting rate for income tax to £10,000, which would be costly - around £23 billion a year. The Budget is likely to contain a watered-down version of the pledge.

Osborne will announce a national insurance "holiday" for firms outside the southeast - exempting companies from paying NICs altogether on the first 10 employees they recruit.

* Capital gains tax
The Chancellor is expected to more than double the current rate of CGT on non-business assets from 18 per cent to 40 per cent - or even 50 per cent - in an attempt to increase revenues.

* Tax credits/child benefit
The potential for saving billions at a stroke has tempted Osborne to consider tapering credits away from families with incomes over £30,000, but it is risky as it threatens to hit core Tory supporters. Likewise, child benefit, which is worth up to £20.30 a week to all families with children regardless of income.

* Public sector to get hammered
An assault upon the state sector is inevitable. The Tories have long complained about a bloated public sector, claiming the Labour years led to an increase in the number of "non-jobs" in town halls, Whitehall departments and other state enterprises.

Prime Minister David Cameron issued a clear warning of the changes to come as he signalled that public sector pay and pensions would have to be restrained. He insisted the Government did not have an anti-public sector agenda but, in a sign that he was prepared to risk industrial unrest, he condemned union leaders who have already vowed to oppose any cuts.

- Additional reporting by Independent