It is hard to find an adjective to describe the state of the public profit and loss account ahead of Tuesday's budget. Bad wouldn't do it justice. Neither would terrible. Shocking is probably closest to the mark.

Only two years ago, we ran a general government surplus of 2.9% of GDP. This year the deficit will be close to 5.5% of GDP, unless the government plans some last-minute slashing of expenditure for the months of November and December.

There are three reasons for the rapid deterioration: tax revenue from property has collapsed, the government lost control of day-to-day expenditure (particularly public sector pay) and the broader economy is now in recession, hitting the rest of the revenue base.

Next year's deficit is likely to exceed this year's, notwithstanding remedial action by government. The economy is set to shrink faster than in 2008: a decline of 3% in real terms is likely and even more in cash terms as the economy experiences deflation. Tax revenue will fall by more, thanks to the geared effect of the property downturn. So before it does anything to improve the bottom line, the government faces a 2009 deficit on the salient EC measure of at least 8% of GDP.

The difficulty for the government is that its options are limited, unless it is inclined to make brave political decisions. One thing it cannot do anything about is increased social welfare spending. That is inevitable as the number of people losing their jobs rises.

The tough decisions concern the rest of spending on public services, the infrastructure budget and tax policy. The cardinal error since 2002 was that windfall property receipts were not a sound revenue base on which to build hard-to-reverse increases in public expenditure. Gross current spending is now at its highest as a percentage of GNP since 1987.

As a consequence, public sector reform is needed immediately. The pay and pensions bill is up by €6.4bn, or almost 50% in five years alone. If public service employment was cut by 30,000, or 10%, excluding the semi-state sector, it would save about €1.5bn in wages. Yet there would be little saving in 2009, due to redundancy payments. So it is imperative to start reducing public sector employment immediately, before the fiscal position slides further.

Ideally, the capital programme would be kept largely intact. But projects that do not add productive potential are dispensable. If possible, we could bring forward other components from future years in the National Development Plan that met rigorous cost-benefit analysis. The economy's productive potential depends on maintaining a high absolute level of capital spending, which of course will underpin an expanding tax revenue base in the medium term. It is time for vision.

The government must avoid tax hikes. Household spending is going to contract sharply next year as employment declines. The burden of debt is so heavy that households cannot withstand further blows. In any case, we tried the tax increase route in the 1980s and it backfired. It won't work this time either.

Ultimately, the shape of next week's budget will differ from the outline above. Significant cuts to the capital programme seem to be telegraphed.

As long as the cutbacks are made in some of the areas of waste identified in the Comptroller and Auditor General's report, public services will not be affected. But that is wishful thinking. Yet next Tuesday's budget will be a relative success if it includes a clear strategy to tackle the bloated public pay bill. Getting our public finances back in shape within three to four years demands it.

Rossa White is chief economist with Davy Stockbrokers