Coming soon to a television screen near you: A Nightmare on Merrion Street IV – the Budget Returns. It may be over six months until finance minister Brian Lenihan is scheduled to deliver what will be his fourth budget. But make no mistake, behind the scenes, the heavy lifting has already begun. Government departments have until tomorrow week to report back to Lenihan with their spending plans for 2011.

This is way ahead of the normal budgetary schedule because the government wants to give itself as much time as possible to discuss the various scenarios for next December's budget. Last year's budget was horrendous – cutting public sector pay and social welfare rates – but the political fall-out was relatively limited. Within government that is being put down to the amount of time spent politically proofing the budget, talking over which decisions could be tolerated and which couldn't.

In contrast, when Brian Lenihan's first budget was brought forward in a rush, the backlash against it was enormous. So in line with this new strategy, departments will have to have presented a good picture of what they will be spending next year. But regardless of how much the government spends mulling over the various options, they are not likely to get any easier.

The upcoming cuts are likely to be the hardest for the public to bear. It would be plain wrong to describe cutting public sector salaries or unemployment benefit as easy.

But having already done that, the government is going to find it extremely difficult to come up with the €3bn in savings it needs for next year. Any low lying fruit has already been picked and given the extent of cutbacks over the last two years, there is a much smaller base now from which to choose.

So how can Brian Lenihan and his cabinet colleagues get to the magic €3bn figure, needed to show the financial markets that Ireland is serious about getting its budgetary approach back on track?

Here we examine the main spending areas and taxation options, and examine the Morton's Fork that awaits the government and indeed the electorate in the coming months.

Capital spending

What's the potential for cuts?

Brian Lenihan has already flagged that €1bn of the cuts will come from capital spending – effectively the amount spent on infrastructure such as school buildings, roads, rail or new hospitals. The government is spending €6.5bn on capital projects this year. It's a massive amount of money given the size of our budget deficit, but experts say it's necessary as a stimulus package and to build for the future. Next year the capital budget will be a maximum of €5.5bn. That shouldn't cause too many problems because with tender prices dropping by 25% to 30%, the government should be able to get far better bang for its buck.

The temptation will be to go for more than €1bn, as cuts in capital spending are less visible than in current, day-to-day spending. In the 1980s, during the country's last budgetary crisis, capital spending virtually disappeared.

That had a massive long-term cost for the economy (the reason why clover leaf junctions are now only being built for the M50 at enormous cost, for example, is that the government wouldn't stump up the relative minor amount of €50m required to build them in the 1980s).

Cutting back on capital spending too much also hits employment in the already decimated construction sector. So it's a tricky balancing act for the government.

Likely savings and fall-out?

The cuts will be limited to €1bn for the reasons outlined above. The political fall-out will negligible.

Public sector pay

What's the potential for cuts?

Virtually none. In last December's budget, €1bn of the €4bn in savings came from cutting public sector pay. However, assuming the Croke Park deal is passed – which now looks likely – the government has agreed not to cut pay further. There will be a fall in people employed in the public sector, but those savings will probably only pay for the increase in the number of new teachers that has been flagged.

Health is the one area where the kind of reformed work practices being promised could lead to a reduction in payroll costs, but it remains to be seen how great those savings are and how early they can be delivered.

Likely savings and fall-out?

Of next December's €3bn savings, the most that can come from payroll savings is €100m-€200m. And that looks like a stretch. Public servants will be relieved at that news and it will be one less headache for the government. However, with €19bn of the €55bn the government spends every year going on pay, it means that €2bn in savings on current spending is going to have to be found from the other €36bn. And that will be very, very painful.

Social Welfare

What's the potential for cuts?

With the public pay bill likely to be unchanged, there is no realistic way the government can pare €2bn off current spending without touching social welfare. However, there won't be much stomach for further cuts in the basic rates of social welfare after last December's cut. With inflation likely to return in 2011, cuts in the rates would be difficult to justify. Child benefit is likely to come back under the spotlight – can it be means tested? Can it be taxed? The same problems that the government found in answering those questions a year ago remain now. The government shied away from cuts in pensions last year, but has pointedly refused to rule out exempting them again next December. Although there are very strong arguments for means testing the state pension, particularly given how high the rate is here compared to Britain, it is political dynamite. Reducing the generous tax exemptions given to pensioners may be a more realistic option (see taxes below). But the difficulty in getting € 2bn of cuts in public programmes may mean that the government has no option but to look at its spend on pensions.

Likely savings and fall-out?

The answer to the first question is almost impossible to guess. The answer to the second is that the backlash will be enormous. With public sector pay now untouchable, the social welfare budget will be hit for another whack.

Health

What's the potential for cuts?

Nearly €1bn was shaved off the health budget last year and with €1 in every €4 the government spends going on health, Brian Lenihan is going to be back for more this year. The problem is that pay roll accounts for two-thirds of the €14bn spend on health and with pay cuts now off the agenda, that leaves only €5bn that can be targeted. Having made savings of €250m on the drugs bill this year, there is limited scope there for further savings next year. While the work practice changes agreed in the Croke Park deal should bring savings to health more than anywhere else, that simply won't be enough. It's impossible to see frontline services not being affected.

Likely savings and fall-out?

Given the size of the health budget, it's difficult to envisage cuts of less than €500m and that's 10% of non-payroll health spending. If services are hit, the reaction will be like the late 1980s – ferocious.

Other departments

What's the potential for cuts?

Education is the other big spending department – alongside Health and Social Protection – but with wages now off limits and the government guaranteeing to increase teacher numbers, there isn't much scope for serious savings. The report of An Bord Snip Nua is likely to be the template for cuts across all the government departments. Many of the recommendations from the report not implemented last year will be this year.

Likely savings and fall-out?

The big ticket items were done in last year's budget so it's going to be more difficult to deliver big savings again. There will be lots and lots of small savings and the hope is that they will add to a decent sum at the end of the process. The problem politically is that this could be the political equivalent of death by a thousand cuts for the government.

Tax

What's the potential for extra revenue?

Apart from cutbacks, the other way of getting to the €3bn target is by increasing the tax take. Brian Lenihan has already signalled that the recent tax increases (by way of income levies) are about as much as the economy can take without running the risk of disincentivising people to work/innovate and leading to diminishing returns setting in. But inevitably there will be some 'wets' in the cabinet who have little stomach for further cutbacks and see tax increases as less painful. That is what happened during the Fine Gael-Labour government of the mid 1980s with disastrous consequences for the economy.

The battle will be fought at cabinet in the coming months. But regardless of what happens in that debate, there will be some tax increases in the budget. The current situation whereby almost half of workers pay no tax whatsoever is unheard of anywhere else in the OECD and is untenable.

In his budget speech last year, Lenihan signalled he would be introducing a new universal social contribution that would replace PRSI, the health levy and the income levy. It would be paid by everyone at a low rate on a wide base "as a collective contribution to public services".

It is widely believed this will be used by Lenihan to bring all earners into the tax net, albeit in a modest way, and he could also reduce the tax credit available to workers to include more low paid.

The generous exemption for over 65s whereby a single person does not pay any tax on income under €20,000 (€40,000 for a married couple) is likely to come under the microscope.

The introduction of a property tax at some point is inevitable, but it is so difficult to implement and politically contentious that it's hard to see it happening in December. Water meters are to be installed in every house in the country in the coming years, but the government could act earlier by introducing a flat charge for water for every household. This will be resisted by the Greens who believe a flat charge would not help conservation and would be more difficult to sell, but given the difficulty the government will have in getting to €3bn in savings, it can't be entirely ruled out.

Likely savings and fall-out?

The maths suggest the government will have to come up with at least €300m-€400m in new tax revenue but, aside from some excise duty increases, it won't be easy. Moves to bring lower paid into the tax net, while inevitable, will be strongly resisted, as will any form of property or water charge – remember the reaction to the poll tax in Britain.