UK public finances: The chancellor's choice Every penny counts: union members masquerade as David Cameron, left, Nick Clegg, centre, and George Osborne during a protest against government plans to cut pensions The cream of British manufacturing is gathered at the Dorchester hotel in Mayfair, a familiar chequerboard of black dinner jackets, pressed white shirts and black ties. There is one notable exception, however: the chancellor of the exchequer has opted for a business suit. But this is no fashion faux pas: it is a glimpse into the mind of a very political finance minister. "I have to leave shortly to chair a Budget meeting, and I'd feel more uncomfortable doing that in black tie than standing here in front of you in my suit," he says. This isn't a political statement. In one deft move, Mr Osborne reassures his audience that he is working all hours to sort out the economy while simultaneously taking a dig at Gordon Brown, the former Labour prime minister famously reluctant to don a tuxedo. There is another possible explanation for Mr Osborne's sartorial selection at the dinner this month. As he prepares for his March 21 Budget, the man credited as the strategic mastermind of the Conservative-led coalition government confronts a nation two years into a period of spending cuts and squeezed real incomes with no end in sight. Does the heir to a junior aristocratic title - one day he will be Sir George - and a member of one of the poshest governments of recent times really want to be filmed in full rig in a swanky Park Lane hotel? The black-tie conundrum is a metaphor for the central dilemma facing the chancellor and prime minister David Cameron in the run-up to the Budget. In a Conservative party associated with the rich and powerful, to what extent are they prepared to dress down in policy terms to secure the votes of Middle Britain that will decide the next election? For weeks, the argument has been raging at the heart of the increasingly tetchy coalition of Tories and Liberal Democrats. Mr Osborne, custodian of the world's seventh-biggest economy (the UK has just been overtaken by Brazil), has been trying to shape a Budget that sends a political message to those in the "squeezed middle" that the government is on their side. Mr Cameron - Eton, Oxford, son of a stockbroker - is just as keen to cleave to the centre ground but he is instinctively nervous about piling pressure on the rich (including Tory donors) to help pay for a transfer of funds to the less well off. As Mr Cameron and Mr Osborne fly off to Washington on Tuesday on a three-day visit, the final details of this most political of Budgets are yet to be resolved. The economic backdrop to Mr Osborne's annual financial statement is stark. "The British government has run out of money because all the money was spent in the good years," he said last month. He makes it plain there will be no unfunded Budget giveaways: "Any tax cut would have to be paid for." Mr Osborne believes, like the Lib Dems, that the strongest signal of support for hard-pressed working families is a further rise in the threshold above which income tax is paid, but he and Mr Cameron are agonising over how to fund it. Lib Dem talk of a "tycoon tax" or a "mansion tax" is anathema to many Tories but is nonetheless politically seductive. "They hate it when we are seen as the "fair" bit of the coalition," says one strategist from the Tories" junior coalition partner. As he grapples with this political dilemma, Mr Osborne can at least console himself that the context to the Budget is less foreboding than in recent times. This is the first financial statement in five years that has not been delivered in a climate of palpable economic emergency. Osborne seeks a cut of the capital's gains To assorted Russian, Middle Eastern and British billionaires taking up residence in one of London's most exclusive new developments, One Hyde Park might be little more than another penthouse to furnish. To the Treasury it represents millions in lost tax, writes Kiran Stacey. Land Registry records show many of the flats were bought using companies registered abroad, allowing the buyer to avoid stamp duty, levied at 5 per cent for properties costing more than £1m. Oligarch Rinat Akhmetov was behind the purchase of one flat, in which his Ukrainian holding company invested, where the tax would have amounted to nearly £7m. As George Osborne, chancellor of the exchequer, looks for ways to fund a series of Budget aspirations, closing this loophole appears attractive. Doing so is not easy, however, and Treasury officials say it is likely to raise only £200m - far short of the sum needed to fund Conservative-Liberal Democrat coalition proposals such as raising the threshold above which income tax is paid from just over £8,000 to £10,000. The chancellor is therefore looking at other ways to tap the capital's housing market, which barely stumbled during the recession of 2008 and its aftermath. While falling prices have been seen elsewhere, those in central London have risen nearly 12 per cent in the past year, according to estate agent Knight Frank - driven partly by wealthy foreign owners. Italians keen to flee economic uncertainty have overtaken Russians as the biggest group of foreign buyers, accounting for 8 per cent of all purchases since January. A policy advocated by Vince Cable, the business secretary, of levying a 2 per cent "mansion tax" on properties valued at more than £2m would target the market Mr Osborne is looking to tap. Research by the Ledbury consultancy suggests six in 10 properties bought for more than £2m last year in the UK were purchased by foreigners; Knight Frank says eight in 10 are in London. Though increasingly popular among modernising Conservatives, it is unlikely to come up in this Budget. A new upper level of the property tax paid to local authorities for services such as waste collection would take into account a disproportionate rise in London prices since properties were valued for the levy in 1991. This, too, is unlikely to be implemented; coalition parties have agreed not to carry out a revaluation in this parliament to avoid both the administration involved and angering those who would end up paying more. Other possibilities include a capital gains tax on first properties valued above a certain amount or raising the CGT rate for everyone who pays it. However, David Cameron, prime minister, is resistant to any wealth taxes, believing they amount to double taxation and penalise people who naturally vote Conservative. In the first part of 2012, Britain's output seems to have recovered from a fall of 0.2 per cent in the final quarter of last year. Business confidence surveys and consumption have surprised almost everyone with their resilience, while the rise in unemployment has slowed. Successful companies such as UK supermarket group Tesco and Japanese carmaker Nissan are announcing new jobs. A leading City of London investment banker, speaking privately last week, said his corporate clients are much more upbeat in private than they dare say in public. David Sproul, chief executive of professional services firm Deloitte in the UK, says clients seem "confident that the next 18 months will be more benign than the last 18 months." The upswing is still fragile, however, and nobody in official circles is taking a strong recovery for granted. Charlie Bean, deputy governor of the Bank of England, said at the end of last month that it was important not to overinterpret a few positive indicators: "It will take a lot more swallows to make a summer." UK officials are chastened by their persistent tendency since 2009 to predict a more durable recovery than has materialised, and this has made caution the watchword. The persistent disappointments since Mr Osborne's first emergency Budget, in June 2010, have prompted a fierce argument among politicians and economists over their cause. The question is the degree to which the weak recovery is the result of government misunderstanding the growth-sapping effects of austerity; the product of global economic shocks over which UK policy could have no influence; or an underestimation of the underlying weakness of UK productivity, which holds back growth. The opposition Labour party has focused all its fire on austerity, blaming the disappointment - and unemployment rising towards 3m - on spending cuts that go "too far and too fast." Mr Osborne preferred, in November's autumn statement, to point the finger at a "debt storm" hitting the eurozone. The independent Office for Budget Responsibility - Mr Osborne's creation, which now produces the official forecasts for the government - in November attributed the entire output shortfall to higher than expected price rises resulting from the run-up in commodity prices towards the end of 2010 and in early 2011, and their effect on household incomes and consumption. "The fact the economy grew less quickly than the interim OBR forecast in June last year can be explained by the external inflation shock," Robert Chote, the body's chairman, wrote in his report. Many City and academic economists agree. "Austerity is a constant headwind to growth, but it started at the beginning of 2010 so it cannot account for the slowdown in 2011," says Kevin Daly of Goldman Sachs. The widespread consensus on the explanation of the growth shortfall to date is music to Mr Osborne's ears. Meanwhile polls suggest that the public continues broadly to support his austerity plan, which aims to eliminate Britain's underlying deficit within five years; almost 60 per cent said the public spending cuts were "necessary" in a recent YouGov poll. With the sense of emergency lifting, Mr Osborne is likely to echo the call by Sir Mervyn King, Bank of England governor, for "patience." So long as the economy is not hit by another external shock, both men believe that in 2012 the end of the squeeze on household incomes will begin, and the real recovery will start. The Budget may not be a game-changer economically, but it will set the terms of the political debate for the rest of this parliament and for the next election, scheduled for 2015. Mr Osborne will be running that election campaign for the Tories and he is already thinking ahead, egged on by members of his party's moderate 301 Group - named after the number of seats the party must win to secure an outright majority. Many in the 301 Group have Budget priorities similar to those of the centrist Liberal Democrats, whose overriding aim is an increase in the income tax threshold closer to £10,000, helping low- and middle-income families. This alignment of views is perhaps not surprising: Mr Osborne knows he must occupy the centre ground and obliterate his coalition partner if the Tories are to win the election. Raising the money is the problem. A crackdown on tax allowances exploited by the wealthy is certain, but it is unlikely to yield enough. So Mr Osborne has floated a number of ideas past Mr Cameron, including higher taxes on properties worth more than £2m or hitting the tax relief given to high earners on their pension contributions. "The flow of information between the Treasury and Number 10 is excellent," says one ally of Mr Osborne. Relations are very good as usual, but there is creative tension. Mr Cameron instinctively opposes higher taxes and feels the rich have been squeezed enough, not least by a 50p top rate of income tax introduced in 2009. He does not like the idea of a "mansion tax" or discouraging people from saving for their retirement: the fact that Mr Osborne is prepared even to consider variations of these essentially Lib Dem policies is a sign that he is less squeamish about targeting the better off - if it means he can command the centre ground. It is a sign of the difference of approach between Mr Cameron and his friend and closest political ally that the prime minister has told his chancellor to find about £500m to soften the impact of the planned removal of child benefit from any household where anyone pays the higher rate of income tax: in other words, the top 15 per cent of the income scale. "Left to his own devices, George would have left the policy where it is," says a colleague. It's very popular. Amber Rudd, a member of the 301 Group, says: "A lot of us support the chancellor on this. We know there is a squeeze on everyone and it's fair that everyone shares that squeeze. Faced with a prime minister reluctant to soak the rich and his own desire to stick to the centre, Mr Osborne is in a bind. And that does not take into account the demands of those on the Tory right who are urging him to cut public spending further to fund tax breaks for business. In perhaps the most totemic argument of all, Conservative rightwingers such as David Davis, a former leadership contender, want Mr Osborne to remove the 50p top rate of tax on those who earn more than £150,000, a levy of dubious economic merit but high political significance. Mr Osborne knows he can do that only if he has cover: in other words, if Mr Cameron lets him raise other taxes on the wealthy. In political terms, it is the equivalent of attending a black-tie dinner in a business suit. If anyone can do this, it is Mr Osborne. In the bar after the manufacturers" dinner, a fellow guest confides: "Osborne went to a black-tie banquet for small business leaders a couple of weeks ago: he wore a business suit and gave exactly the same excuse."