The scope for significant tax cuts in the new government’s budget has been reduced after gloomier predictions for the public finances from the Treasury watchdog showed higher levels of public borrowing and a deterioration in the British economy.

The Office for Budget Responsibility (OBR) warned that government borrowing was on course to be about £20bn higher than previously expected in each year to 2023-24, dramatically cutting the government’s room for manoeuvre after Boris Johnson’s election victory.

Closely watched business surveys suggested the British economy is on the brink of its second quarterly contraction this year after the private sector recorded its worst downturn in three years in December.

Presenting Johnson with an early economic challenge to handle at the outset of his renewed term in office, the OBR said weaker economic growth at home and abroad was having an effect on the public purse. It also reclassified the way student loans are accounted for in its forecasts for the government finances.

Jack Leslie, an economic analyst at the Resolution Foundation, said the OBR statement was a sobering warning to ministers. He said: “Even a small deterioration to the economic outlook, or plans to cut taxes, would see the chancellor at serious risk of breaking his brand new fiscal rules. Looking ahead, tax rises rather than tax cuts will be needed if those fiscal rules are to be combined with rolling back the impact of austerity over the course of the new parliament.”

Meanwhile, IHS Markit and the Chartered Institute of Procurement and Supply (Cips) said that business activity slumped before the election, against a background of intense political uncertainty, a lack of clarity and a subdued international economic outlook. As a consequence, it warned that Britain was set for a quarterly decline in GDP in the final three months of 2019.

The decline would mark the second contraction this year, after the economy slid to the brink of recession in the second quarter. Although growth returned in the third quarter, another slump in the fourth quarter would suggest that the UK economy is close to its weakest point since at least 2012.

According to the survey, conducted before the election, the rate of decline across the private sector was the fastest since July 2016, immediately after the Brexit vote. Employment levels fell for the fourth consecutive month in December, linked to a pause in decision-making and subdued new orders for firms as they awaited the outcome of the vote.

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The flash purchasing managers index (PMI) slipped to 48.5 from 49.3 in November, below the expectations of City economists and below the 50.0 mark that separates economic growth from contraction.

Brexit-related aversion to investment among companies and a pre-election lack of consumer confidence contributed to the decline, while manufacturing production dropped at the greatest extent for almost seven-and-a-half years.

The OBR warned that the government’s budget deficit – the gap between tax income and public spending – would balloon to about £47.6bn this year, about £18bn higher than previously expected.

Despite successive years of Conservative attempts to balance the budget through a policy of austerity, the OBR said that borrowing was still set to be £33bn in 2023-24, about £20bn higher than forecast in March this year.

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The OBR said it had not yet taken into account decisions made at the spending round in September, which promised the biggest increase in spending for more than 15 years. The forecasts also do not include promises made in the Tory manifesto for higher public spending and tax giveaways.

Despite the warnings for the economy, the outcome of the election could help to restore confidence in the months ahead, said Duncan Brock, the group director at Cips. Britain’s largest companies gained more than £30bn in value on Friday as financial markets rallied on Johnson’s victory, amid hopes in the City that the Tory majority would lift some of the political uncertainty facing Britain. Shares made further gains on Monday, boosted by the trade agreement between the US and China, sending the FTSE 100 index up another 2%.

However, Johnson has left the option of no-deal Brexit on the table for the end of December 2020, which could hold back the economy. Brock said: “The Brexit path is still littered with obstacles and the need for strong negotiation skills for a future EU agreement will be paramount to avoid this downward slide becoming the economic landscape for an extended period.”