The Organisation for Economic Co-operation and Development has slashed its growth forecast for the UK next year, saying the government's deep spending cuts will increase the "headwinds" facing the economy and "hamper growth".

The Paris-based thinktank welcomed the coalition government's "ambitious medium-term plan" to cut spending, because it has "significantly reduced fiscal risks". However, as a result of the austerity measures, it now expects GDP growth to slip to just 1.7% next year, compared with its May projection of 2.5%.

The OECD's forecast for 2011 is significantly more pessimistic than the UK Office for Budget Responsibility's own projection that the UK economy would grow by 2.3% in 2011.

"The substantial but necessary fiscal tightening and weak real income growth create headwinds, and growth is projected to remain subdued in 2011," the OECD said.

The OECD, which is funded by 30 countries, also revised its forecast for growth this year up to 1.8%, from 1.3% in May. This is more bullish than the OBR's forecast of 1.2% growth in 2010. The consensus among City economists is that the OBR's 2010 forecast is too low while next year's estimate is too high.

"GDP growth in the first three quarters of 2010 was robust, reflecting broad-based growth in domestic demand, including from a needed rebuilding of inventories," the OECD said. "The pace is set to slow, however, as contributions from stockbuilding fade and fiscal consolidation creates increasing headwinds."

The OECD explained that government spending and investment would fall "significantly" next year while household spending was set to remain subdued owing to slow real income growth and stagnant asset prices, such as house prices. It said that a pick-up in exports, supported by improving global demand and a weak pound, should underpin a stronger recovery in 2012, when it predicts Britain will grow by 2%.

The OBR will update its own forecasts on 29 November. It said today that it has calculated that the VAT increase to 20% from 17.5% in January would reduce the level of GDP in 2011/12 by 0.3%.

Global growth forecast cut

The picture in the eurozone is similar, with the OECD expecting growth of 1.7% this year and next, picking up to 2% in 2012. The OECD cut its global growth forecast for next year to 4.2% from 4.5%, predicting a "soft spot" as governments withdraw their economic stimulus measures.

British retail sales recovered last month after two months of declines, the UK's Office for National Statistics said this morning. However, the recovery is likely to fizzle out in the new year when the VAT increase kicks in. Analysts said it was prompting consumers to bring some purchases forward and that the outlook for 2011 was bleak. "Clearly this will just store up weakness for the start of 2011," said Samuel Tombs at Capital Economics.

UK government borrowing came in at £10.3bn in October, excluding the impact of the banking bailout – a record for the month and compared with a £10.1bn shortfall a year ago, separate figures showed.

However, thanks to some favourable revisions to previous data, the public finances are showing a slight improvement in the fiscal year so far. The government borrowed £81.6bn between April and October 2010, compared with £87.5bn at over the same period last year.

"Consequently, chancellor George Osborne remains on track to meet his target of £149bn [borrowing] in 2010/11 and could even undershoot it, although much will depend on how well economic growth holds up over the rest of the financial year," said Howard Archer at IHS Global Insight. "If current trends are replicated over the whole fiscal year, borrowing would come in around £145bn."