In challenge to Labour, chancellor tells MPs billions will need to be shaved from welfare to avoid deeper departmental cuts

A fresh attack on Britain's welfare budget was announced by George Osborne as he told MPs he would prefer to cut benefits than slash the size of the state to its smallest since the 1940s.

In a calculated challenge to Labour in the runup to the next election, the chancellor said many more billions would need to be shaved from welfare to avoid deeper cuts in spending by Whitehall departments.

"Welfare spending can't be excluded from the difficult decisions," the chancellor told a hearing of the Treasury select committee into last week's autumn statement. This showed that the government's plan to balance its books by 2018-19 would require an acceleration in the cuts to departmental budgets from 2.3% in the current parliament to 3.7% between 2016 and 2019.

The Office for Budget Responsibility, charged with forecasting the economy and the public finances for the Treasury, said that would leave day-to-day spending by government at its smallest share of national output at least since modern records began in 1948. On current plans, cuts to government departmental budgets will be 8% by the end of the current financial year and reach 20% by 2018-19.

"That assumption is based on an erroneous assumption about what the political system would do," Osborne said as he announced that next year's budget would be held on 19 March. "On current plans that is what it shows, but the next government will want to undertake further reductions in the welfare budget. If it does that you don't reach the 1948 number."

The chancellor sees welfare as one of the defining political issues at the next election in 2015, and believes his hardline approach will create difficulties for the Labour opposition.

While refusing to put a precise number on the size of the welfare cuts, Osborne accepted they would run into "many billions" of pounds. The Institute for Fiscal Studies (IFS), the UK's leading thinktank on government spending, has said welfare cuts or tax increases totalling £12bn will be needed to avoid a stepping-up of the cuts to government departments.

Osborne said he agreed with the IFS analysis, adding that politicians had to be honest with the public. The chancellor said his priority was to protect spending on education and science. "We shouldn't be cutting these things because we are not prepared to deal with the welfare budget.

"I don't think all the savings need and should be made within the departments. I think we should make a balanced judgment about where government spends its money and, yes, we have got to make difficult decisions to save money further in Whitehall but we should accompany that with savings in the welfare budget."

In a two-hour appearance in front of backbench MPs, Osborne made it clear that he would call time on the government's Help to Buy subsidies for house purchases after three years and denied that the scheme was helping to create a bubble in the property market.

The committee's chairman, Andrew Tyrie, asked the chancellor to respond to allegations that he was "adding vodka to the punch bowl just as the party gets going" by giving state-backed guarantees for the first 20% of home loans up to a value of £600,000.

But Osborne said the Bank of England's new Financial Policy Committee had been given the powers to "take the punch bowl away" if the recent recovery in the property market threatened to get out of hand.

"The early evidence from Help to Buy is that three quarters of those taken out are not living in London and the south-east," said the chancellor. "The average house purchase that they have been looking for is £160,000 – that's below the national average. In other words, it is dealing with exactly the families we want it to help."

Challenged over falling living standards in the current parliament, Osborne blamed the "calamity" of 2008-09, when the UK suffered its "worst recession in modern history and the biggest banking crisis in its entire history".

Although figures from the Office for National Statistics show that inflation has continued to erode living standards since the recession ended in 2009, Osborne said: "The country is poorer as a result of what happened in 2008-09."

Meanwhile the new head of sovereign debt ratings at Fitch said the agency would not be in a hurry to upgrade Britain's debt rating to the coveted AAA.

In an interview James McCormack said the economic rebound this year had been "a pleasant surprise for everyone" but settling questions over its sustainability enough to win back the top-notch rating was "going to take some time".