CAUGHT between a rock and a hard place; a catch-22; a Morton's Fork; between the devil and deep blue sea. Take your pick of idioms to describe the dilemma the government faces following last week's estimate of the final cost of the bank bailout.

If the government maintains its commitment to reduce the budget deficit to 3% of GDP by 2014, the cutbacks involved risk killing off any growth prospects for the economy. If it doesn't maintain that commitment, the cost of borrowing the billions it needs to keep the state running is likely to soar to levels that are going to result in even bigger cutbacks so the state can make its interest repayments.

Neither option looks good. It's clear the coalition is committed to the former while, as much as it can, maintaining a balancing act of picking the measures that, in the words of one government source, "do the least damage to the economy".

Easier said than done. The same source acknowledges that "everything is under discussion. Everybody will have to contribute". But as economist Colm McCarthy, author of the An Bord Snip Nua report, puts it, they have no choice. A clear signal has to be sent to the financial markets that Ireland is serious about tackling its deficit. Without it, our borrowing costs will become unaffordable.

But the economic and political consequences of sending that signal cannot be underestimated. Last year's budget was widely and accurately described as the toughest in the history of the state but it is now going to have to hand on that very dubious honour to its successor, Budget 2011. That, in turn, may need to make way for Budget 2012 and so on and so on.

There is no question that, even without the banking bailout, massive cutbacks would have been required. As everyone now knows, the government is spending €18bn more than it is taking in from taxes every year. When national debt finally peaks at an estimated €130bn, something between a quarter and a third of that sum will have been caused by the bank crisis – the remainder, and the vast majority, by the enormous annual deficits the government is running. But there is no question that the cost of the bank bailout has made an already very difficult situation a whole lot worse.

It was bad enough having to come up with a budget with €3bn in savings. Now it seems the target is over €4bn, with some predicting it may need to be as high as €4.5bn.

It's true the government managed savings of €4.2bn last year. But €1bn of that came from public-service pay cuts, which are ruled out by the Croke Park agreement. And the pool from which the cuts must be drawn is clearly a lot smaller than it was last year. Any low-lying fruit has been picked long ago.

There will also be an enormous reluctance to repeat last year's across-the-board cut in social-welfare rates – although the size of savings the government needs to achieve may mean there is no choice.

Opposition 'terrified'

Some government figures were surprised that behind the 'Black Thursday' soundbites, there was, they felt, a somewhat muted reaction from the opposition parties to the announcements from finance minister Brian Lenihan.

"They're terrified by it all," was the verdict of one source. "Because the certainty is that they'll have to do the same thing [when they get into power]."

The two main opposition parties are talking tough about getting the government out of office as quickly as possible. But do Fine Gael and Labour really want a general election before the December budget is out of the way?

The menu of options from which the government has to choose in drafting that budget is extraordinarily limited and very unpalatable.

There are three main areas from which the €4bn-plus savings can come: capital spending, current spending and taxation.

The government has already pencilled in €1bn in cuts from the capital budget, which it claims can largely be achieved without too severe an impact on projects because of substantially lower tender prices for construction. That €1bn reduction is now certain to be increased, possibly by another €0.5bn.

There are solid arguments against this. Public infrastructure projects can act as an effective stimulus to a stagnant economy and it's possible to get good value for money at the moment. But the political reality is that cuts in capital spending are far less contentious than those in current spending. And politics generally wins out over economics.

There were some suggestions last week that flagship projects such as the Dublin metro would have to be shelved. Certainly, it seems strange to be proceeding with such a blue-chip development, however desirable it may be, at a time when the country is struggling to make ends meet. A few weeks back, the government included the project in its revamped infrastructure programme, suggesting there won't be any row-back. Then again, our circumstances have changed pretty dramatically in that short time.

When it comes to current spending, every government department is going to feel the pain, with the departments of Defence and of Tourism, Sport and Culture getting hammered. But two-thirds of current spending goes on public-sector pay and pensions and on social welfare. And, in real terms, that is where the axe is going to have fall most heavily.

The government bottled it last year when it exempted public-sector pensioners from the across-the-board pay cuts it introduced. Public-sector pensioners had benefited hugely from the large pay increases given to state workers over the previous decade. Logic dictated that they should have also taken a hit when public-sector pay was cut.

However, the government was so scarred by the pensioner revolt over the ending of universal medical cards for over-70s the previous year, that it decided against the move.

Government sources now suggest there might be a legal impediment to cutting public-sector pensions and the coalition is further impeded by guarantees it gave in the Croke Park agreement, which, with each passing day, is looking like a better and better deal for the unions. But the government is very likely to look at the generous tax credits enjoyed by all those over 65, and the exemption they get on Dirt tax, as a means of raising revenue.

The days of public-sector pensions being linked to increases in wages of existing state workers also look numbered. For obvious reasons, the government is keen to change this so that pensions are linked to inflation. Again, the Croke Park deal has long-fingered the move somewhat but it is likely to be in the government's medium-term plans.

In the short term, however, the only way of getting the pay bill down is by reducing numbers. This will not prove easy. There is no money for a voluntary redundancy programme, and with unemployment running so high, there is not much incentive for public-sector workers to jump ship to the private-sector. Somehow, though, numbers are going to have to be cut.

Reducing the social welfare bill is not as restricted by deals with the unions but there are significant political and equity considerations.

Social welfare cuts

Some of the savings will come from reform of the welfare system. It is known, for example, the government is looking at the system of paying social welfare for a six-day week, allowing people who work for three days to claim benefit for three days.

The old-age pension probably remains a no-go area for most ministers because of the upset it would cause and the political fall-out. But none of the other social- welfare payments, including child benefit, can be ruled out for cuts.

The Department of Social Protection has already brought forward proposals for savings of €200m but the cuts are going to have to be a lot more severe than that. Last year, the department endured cuts of €760m and the overall budget still went up by €700m because of rising unemployment. In relation to the other departments, the An Bord Snip Nua report is likely to be the template for finding the required savings.

It seems certain that at least a quarter of the €4bn-plus will have to come from additional taxation. If at all possible, Lenihan will want to avoid any more increases in the tax rates. After the introduction of the levies, he believes any further hikes would be self-defeating and damage productivity.

But the current system whereby half of all workers pay no income tax – compared to an EU average of 15%-20% – will end. This can be done by lower tax credits or via the new universal social contribution, which will replace PRSI, health and income levies and which everybody will have to pay.

Government sources concede that, however necessary this move is, it will be perceived as an attack on lower-income workers.

"We are very conscious that there will have to be balancing measures. We will look to cut down on tax exemptions [for the better-off] and we could also remove the PRSI ceiling, which currently stands at €75,000," one senior figure said.

Because of the obvious need to generate revenue, a property tax looks increasingly inevitable, despite the enormous public opposition to it. The only question is, will it happen in the next budget or will it be flagged for a year or two down the road when the government reveals its revised four-year budgetary framework in November?

Property tax 'on the table'

The proposal to introduce a site valuation tax – arguably the fairest property tax system – in the programme for government would take years. But the option of a temporary flat-rate property levy remains.

Planning minister Ciarán Cuffe recently floated the idea of introducing a property levy with different tiers based on the size of the house. It would be simple to introduce. Cuffe removed the suggestion from his blog because it clashed with party policy, which favours a site valuation tax. But as one Fianna Fáil TD joked this weekend, "he might be putting the blog back up again". Even Green Party sources now agree that this option is very much "on the table" for discussion in the coming weeks.

Then again, pretty much everything is. A lot will be revealed in a month's time when the government publishes its revised four-year plan. And if there are any lingering doubts about what future budgets are going to entail, they will be quashed on 8 December. Catch-22? Morton's Fork? More like Hobson's choice, it seems. No choice at all.

'We are crossing the Rubicon'

"We have a banking system which has over the last long number of years had good profits, been in a healthy state and well capitalised"

Taoiseach Brian Cowen on 30 September 2008

"The cheapest bailout in the world so far"

Minister for Finance Brian Lenihan on 24 October 2008

"We are not rushing into the banks like some governments in other countries without knowing precisely what the position is in those banks"

Brian Lenihan on 19 November 2009

"The worst is over; recent indicators suggest that economic activity in this country is turning the corner"

Finance Minister Brian Lenihan in his Budget speech on 9 December 2009

"We were sold a pig in a poke"

Ned O'Keeffe, Fianna Fáil TD for Cork North-East, gives his analysis of his own government's banking strategy on 29 September 2010

"We are today crossing the Rubicon. There can be no turning back. It is the final step on a journey on which the government is taking us, which at every milestone to date the government's claims have been proved ill-founded"

Fine Gael's Richard Bruton on 31 March 2010 after the NAMA loans transfer

"Contrary to assertions that Anglo was too big to let fail, it was too big to save. We shouldn't have gone there"

Fine Gael's Michael Noonan on 29 September 2010

Crunching numbers

€4-€4.5bn

The likely level of savings the government is going to have to find in the upcoming budget

3%

The target the government is trying to achieve by 2014 for the budget deficit as a percentage of GDP

€1bn-plus

The amount in new taxes that will have to be raised in the budget

50%

The percentage of workers currently exempt from income tax – something which will be addressed in the budget

4

The number of tough budgets that lie ahead

€1.1bn

The cuts in current spending in social welfare, education and health already identified. More will be needed