Chancellor plans to slash welfare bill by £2.5bn for people who are disabled or too ill to work

Secret plans to slash the welfare bill by £2.5bn for people who are disabled or too ill to work are being up drawn up by the chancellor, George Osborne, documents leaked to the Observer reveal.

Details of the plan, spelled out in a confidential letter from Osborne to Iain Duncan Smith, the work and pensions secretary, sparked a furious row as Labour accused the coalition government of targeting "the most vulnerable people in the country" with "shocking, arbitrary cuts".

The letter, written by Osborne on 19 June to Duncan Smith and circulated to David Cameron and Nick Clegg, will fuel mounting concerns that the government's assault on spending – and particularly Osborne's determination to slash the cost of welfare – will hit those on the lowest incomes the hardest.

Despite official insistence that no decisions have yet been made on where the axe will fall, Osborne stated in the letter – written three days before his emergency budget – that agreement had already been reached to impose deep cuts on the budget for employment and support allowance (ESA) – the successor to incapacity benefit. ESA is paid to those judged unable to work because of illness or disability.

Osborne told Duncan Smith: "Given the pressure on overall public spending in the coming period, we will need to continue developing further options to reform the benefits as part of the spending review process in order to deliver further savings, greater simplicity and stronger work incentives.

"Reform to the employment support allowance is a particular priority and I am pleased that you, the prime minister and I have agreed to press ahead with reforms to the ESA as part of the spending review that will deliver net savings of at least £2.5bn by 2014-15."

In a further extraordinary development, sources within Duncan Smith's department turned their fire on the Treasury, insisting nothing had been decided and suggesting Osborne's department may have leaked the letter to bounce them into accepting the plan.

With under six weeks to go before Osborne's comprehensive spending review, senior ministers are growing increasingly sensitive to charges of unfairness. Last week, Nick Clegg sought to dispel anxieties by pointing out that the cuts would not fall at once, but over five years. And, in an article for the Observer, Cameron insists that the government's commitment to devolve power from Whitehall to the people is driven at least in part by the quest for greater "fairness".

"There's the efficiency argument – that in huge hierarchies, money gets spent on bureaucracy instead of the frontline. There's the fairness argument – that centralised national blueprints can entrench unfairness because they don't allow for local solutions to major social problems. And there's the political argument – that centralisation creates a great distance in our democracy between the government and the governed," the prime minister argues.

A spokesperson from the Department for Work and Pensions said Duncan Smith, who is battling with the Treasury over potentially costly plans to improve incentives to get people off welfare and into work, would agree to nothing that would hit the vulnerable. "We are looking at a range of options for welfare reform and any decisions will be made in the context of the spending review. Our reforms will ensure that the most vulnerable in our society are protected."

The leak provides an explosive backdrop to the political conference season, which opens tomorrow with the start of the Trades Union Congress in Manchester. The TUC will unveil a report on Monday claiming to show that the Conservatives have betrayed their election promise to introduce cuts fairly and protect public services, as the unions prepare a co-ordinated response to the measures.

Government insiders admitted that limits to the time that people could spend on ESA were being considered, as were plans to means test recipients. But they insisted nothing would be done that would affect those who were judged as having no potential future chance of getting into work.

Jim Knight, the shadow employment minister, said: "The budget was already going to hit most ESA claimants hard; according to government figures, by over £900 if they are also on housing benefit. Now we see the Tories and Lib Dems are conspiring to take thousands of pounds from the most vulnerable.

"This exposes George Osborne's rhetoric about living on benefits as a 'lifestyle choice', as being a smokescreen to hide vicious cuts on the poorest. It also shows that Iain Duncan Smith will cave in to the Treasury rather than deliver the sensible long-term reforms he talks about."