Chancellor urged to accept some ‘loss of face’ to avoid lasting damage to Tories amid warnings his spending plans will force him to slash child tax credits

George Osborne is facing a pincer movement involving senior figures in Downing Street, the Department for Work and Pensions and Tory grandees, advising him to slow the pace of his planned £12bn in cuts in welfare spending.

Amid warnings that the chancellor will have to target child tax credit – the key measure for tackling child poverty – there are calls for Osborne to suffer a “bit of a loss of face” to avoid inflicting lasting damage on the Tories.

The pressure on the chancellor, who is planning to outline the broad details of his cuts plans in his budget next month, comes after David Cameron severely restricted the room for manoeuvre on welfare cuts by ruling out any changes to child benefit.

The move by the prime minister during the election campaign has meant Iain Duncan Smith, the work and pensions secretary, has no choice but to look at taking the axe to tax credits, including child tax credits, and housing benefit. The Institute for Fiscal Studies reported in its green budget in February that the chancellor could save £5bn by reducing the child element of tax credit back to its real terms level from 2003-04 when Labour expanded the measure.

Fears are being voiced at senior levels in Whitehall that targeting tax credits could inflict “enormous damage” on the Tories by hitting the working poor, who are meant to be at the heart of the new blue-collar Conservatism championed by Cameron in the election.

Facebook Twitter Pinterest Philip Hammond has joked that restricting UK workers’ access to tax credits in the first four years of a job would solve Cameron’s treaty re-negotiation problem. Photograph: Antonio Olmos/The Observer

One Whitehall source, whose concerns are shared among senior strategists in No 10, told the Guardian: “If we went after the working poor, we could gift the Labour party an easy route back. So the choice is: do we risk inflicting enormous damage to us at a time when we are riding high or do we accept that there will have to be a bit of a loss of face.”

The battle within the party is disclosed as part of a Guardian report into the challenges facing the first majority Tory administration in two decades, as the prime minister faces the prospect of a Tory split over the EU and a backbench rebellion over his plan to scrap the Human Rights Act.

The report discloses that Philip Hammond, the foreign secretary, joked at a recent meeting that the government could kill two birds with one stone in two key areas – the EU negotiations and the £12bn welfare cuts – by denying all UK workers the right to claim tax credits for their first four years in work.

Hammond quipped that this would save billions of pounds and would ease his EU negotiations because government lawyers have advised him that barring EU migrants from claiming in-work benefits for four years – one of the prime minister’s main demands – would be discriminatory under EU law and would therefore require treaty change.

Conservative division: could history be repeating itself over EU? Read more

The report also reveals that Andrew Mitchell, a leading light in the Runnymede group of Tories opposed to repealing the Human Rights Act, said the plan would be blocked in the Commons and the Lords, indicating he is motivated in part by his experience in the Plebgate affair. Making clear that people will always need access to an outside appeals system in the European court of human rights, Mitchell said: “The British justice system is … for the very rich, the very poor and the very foolish. I place my own experience firmly in the latter category.”

Cameron, who nearly provoked a revolt by ministers earlier in the week by appearing to suggest opponents of Britain’s EU membership might have to resign before the referendum campaign, is facing an intense internal battle over the chancellor’s planned welfare cuts. Osborne announced before the election that £12bn would need to be cut from the welfare budget by 2017-18 as part of a £30bn fiscal consolidation designed to pave the way for an overall budget surplus by 2018-19.

Duncan Smith indicated that he could deliver the cuts, which amount to 10% of the non-pensioner element of the welfare budget. But he made clear that this could not be done by “cheese-paring” and would have to involve what he calls “behavioural change” from recipients by, for example, limiting child benefit to the first two children.

Blocking child benefit changes means the proportion of the non-pensioner part of the welfare budget needing cuts has increased from 10% to more than 20%. It is understood that Osborne will be told that sticking to his timetable would mean cutting child tax credit. Some ministers believe the chancellor will rule out such a politically explosive move, strengthening the argument to slow the pace of the cuts. “Child tax credits are talked about, but it will probably be ruled out,” one senior government source said.

Facebook Twitter Pinterest Andrew Mitchell has vowed to block plans to repeal the Human Rights Act. Photograph: Darren Staples/Reuters

A senior Tory said he expected Osborne to follow the precedent set in the last parliament – slow the pace of deficit reduction to avoid crippling cuts. “Experience tells us that, probably, it will be slightly slower than was intended. Meanwhile, the counter-threat and the counter-argument is that if you slow it down and let it move more gradually, [there is] the danger of another shock coming along that blows you off course and prevents you moving in the right direction.”

The chancellor will be wary of slowing the pace of welfare cuts in light of his fiscal consolidation commitment. A slowing down would also jar with his new pledge to ensure the government always runs an overall budget surplus in “normal times”.

But Osborne could technically slow the pace under current rules and still run a budget surplus by the time of the election in 2020. He is due to run a budget surplus of 0.2% in 2018-19 and 0.3% in 2019-20.

A Treasury source said: “The government was elected on a clear set of projections that involve the fiscal consolidation that is to be achieved by 2017-18. All else is pure speculation.”

Andrew Hood, of the IFS, said cutting child tax credits would hit poor families. He said: “What you are doing there is taking a large amount of money off low-income families, both in and out of work. The IFS green budget suggests that that would have an impact on tackling child poverty. The big working-age benefits that are currently unprotected are tax credits, housing benefit and disability benefits. So, looking at £12bn, they have got a relatively limited set of options. It would be surprising if tax credits were off the table.”

A Foreign Office source said of Hammond’s intervention: “We’ve always been clear that we will need treaty change in some areas.”