The latest Exchequer returns dampened even the most optimistic economic commentators' spirits. Without doubt, the figures are bad. After years of double-digit growth in revenue, the latest returns show a marked turnaround in the public finances.

For the year to the end of September, tax revenues are up a mere 2.2 per cent, a long way short of the original target of more than 12 per cent.

The impact on the Government's projected surplus is striking. A surplus of £2.5 billion (€3.17 billion), or 3.2 per cent of GNP, was forecast on Budget day. With tax revenues down by £1.5 billion and total expenditure in line with projections, a surplus of around £1 billion (or 1.3 per cent of GNP) is now forecast.

It is this changed outlook that the Minister for Finance, Mr McCreevy, must consider in framing his next Budget. There is much speculation about the implications for future tax and expenditure plans. Mr McCreevy is not short of advice. But what do the latest numbers mean for future plans? What tax and expenditure scenarios for next year are now realistic?

Mr McCreevy's so-called room for manoeuvre depends on two critical factors. Firstly, what is the likely short-term economic outlook? And secondly, what should be the Budget target given the emerging economic situation?

Of course, economic forecasters don't have an enviable record, but the economic outlook is now more uncertain than it has been in a decade. The economy was weakening even before the events of September 11th. The slowdown in the US was spreading and having a significant impact on exports and output in the Republic.

Combined with the effects of foot-and-mouth, this slowing international environment was weakening business and consumer confidence. This in turn has led to a slowdown in private spending. The attacks of September 11th will further weaken confidence, while having a considerable effect on a number of sectors.

Short-term prospects will depend primarily on the extent and duration of the international slowdown. International conditions should be improved by lower interest rates, lower oil prices and the effects of expansionary fiscal policy. Nevertheless it is likely that the world economy - and the Irish economy - will remain sluggish until at least the first half of next year.

Unless economic conditions take an unexpected turn for the better, Mr McCreevy is likely to base his plans for next year on a modest growth scenario.

Such a scenario was contained in the ESRI's latest Medium-term Review, 2001-2007. Under a so- called "slowdown scenario", growth in GNP of just 1.8 per cent is forecast for next year. This would be a more significant downturn than in other countries, reflecting the openness of the Irish economy.

The Central Bank takes a more upbeat view. In its most recent assessment, growth in GNP of 3.5 per cent is projected for 2002. This seems a reasonable projection to adopt. Assuming economy-wide price increases of about 2.5 per cent, these projections suggest that nominal GNP might increase by around 6 per cent next year.

With growth rates of this magnitude, what potential scope does Mr McCreevy have for tax cuts and/or expenditure increases? Table 1 shows a breakdown of estimated tax and expenditure aggregates for 2001, and projections for 2002. The Department of Finance's assessment of the out-turn for 2001 are used. For next year, tax receipts increase by 6 per cent in line with assumed economic activity, implying very modest tax cuts of less than £500 million in a full year. This compares with tax cuts of well over £1 billion in last year's budget.

Implementation of the National Development Plan requires increases in capital expenditure of about 12.5 per cent in 2002, based on last year's budget projections. To maintain an unchanged Exchequer surplus, this illustrative scenario allows only very modest increases in expenditure. Such allocations would clearly not be enough, given prospective expenditure pressures. The cost of delivering the current levels of public service next year will require additional expenditure to meet, inter alia, expected increases in public sector pay.

These budgetary figures clearly point to the tight position Mr McCreevy faces.

Of course, he could budget for an even lower surplus in 2001 than the expected outcome for this year. By reducing the surplus we could afford higher expenditure or large tax cuts. Would this be an appropriate response for budgetary policy in current circumstances?

Views differ on this. Given the uncertain outlook and the possibility of below-trend growth, some would consider it sensible to continue with a surplus for some time. This would enable policy to support growth if economic conditions turned out to be worse than expected. Recent developments would urge such caution.

An alternative view is that the surplus should continue to fall as the economy decelerates. Governments run surpluses to prepare for a slowdown and current conditions fit the bill. The economy's so-called automatic stabilisers should be allowed to work - especially where the real level of Government debt is low.

Under this scenario, the Budget should move back into broad balance if growth slowed as markedly as the ESRI and the Central Bank expected. This approach would be consistent with the fiscal rules of the Stability and Growth Pact.

Nevertheless, this might still land the Minister in trouble with a European Commission still worried about overheating - although in keeping with precedent, the Commission's concerns could be cheerfully ignored.

The snag is that given the scale of the tax revenue slowdown, reducing the surplus further would make life only marginally easier for the Government. Targeting a surplus of around £500 million, for example, would allow non-central fund spending to rise by around 6 per cent (see table 2). This is a fraction of the current rate of expansion and would allow for no real improvements in services.

Therefore, Mr McCreevy faces a clear dilemma. Whichever way the numbers are crunched, hard economic choices will have to be faced. To deliver investment plans consistent with the National Development Plan (NDP), budget for a surplus of £500 million and allow current expenditure to rise only modestly leaves room for only around £500 million in tax cuts. This is well below current commitments.

Ultimately, these budgetary decisions will reflect political choices. But proceeding with the timeframe of the NDP is clearly an economic priority. Failure to address our underdeveloped infrastructure will hinder future prospects. Moreover, the delivery of the programme may now be more realistic as labour shortages should be less of a problem as the economy slows.

Existing plans for services such as health and education will lead to higher costs next year, even without further service improvements. Restricting expenditure would jeopardise current plans - notwithstanding the demand for service improvements.

Given the new Budget reality, the case for further tax cuts is harder to make. Taxation as a proportion of national income has already fallen dramatically in recent years and is now lower than all other European countries. The current burden of taxation implies a lower level of public services than is likely to satisfy the public's demands. Further reductions could lead to greater budgetary pressures in the future.

Above all, the new budgetary circumstances require a more rigorous assessment of options. The dismal scientists are due for a return.

Robert Watt is a senior economic consultant with Indecon Economic Consultants. He was formerly a senior official with the Department of Finance.