TAX cuts of around £3 billion designed to portray the Conservatives as the natural tax cutting party are expected to be announced by the British Chancellor of the Exchequer, Mr. Kenneth Clarke, tomorrow. In a "prudent" annual budget Mr. Clarke will stake his claim to be Mr Major's heir apparent as Tory party leader.

With the Tories trailing so far behind Labour in the opinion polls election defeat for Mr Major's administration looks to be well nigh certain - and after defeat will come selection of a new leader of the Conservative Party. The crucial dilemma for Mr Clarke will be to grab the headlines and the hearts of Tory MPs by sanctioning highly visible cuts in personal taxes without inviting an adverse reaction from the financial markets by large scale fiscal give aways.

Majority opinion among economists is against fresh fiscal stimulation of any substance at a time when there are distinct signs of a new consumer spending boom fuelled by cheap money and inflationary pressures are beginning to intensify. With jobless numbers continuing to fall, unemployment is expected to fall below two million in the next month or so. But the tightening labour markets are being accompanied by higher pay settlements.

Further, the government's own finances still leave a lot to be desired with public borrowing way above forecast due to the combination of increased public spending and sluggish growth in tax revenues. A year ago, Mr Clarke forecast that this year's public sector borrowing requirement would be just on £22 billion. This was increased to £27 billion in the Treasury's midsummer economic forecasts - and City pessimists believe it could hit £29 billion.

While the economy is performing well, the government's finances still look to be in serious disarray. The financial markets are discounting modest tax reductions, but anything that smacks of pre election largesse could precipitate a negative response on the money and currency markets.

After last month's 0.25 per cent increase in interest rates to 6.0 per cent, Mr Clarke could get away with another quarter point rise in the next month or so without too much damage. But his claim to be John Major's heir apparent will suffer a severe blow, if the political capital of Budget tax cuts is destroyed through much higher rates forcing increases in mortgage rates during the approach to the General Election.

Most City analysts believe there is scope for Mr Clarke to create the impression of significant reductions in personal taxation without upsetting the markets unduly. Although inflation has begun to edge upwards again this autumn, the Treasury's economic forecasts are likely to be based on achieving lower than expected inflation rates next year. This should provide some leeway for tax cuts by lowering public spending forecasts.

Also, the sluggish growth of tax revenues during the economic recovery driven by exports so far may well be transformed by the onset of the consumer spending boom.

Widely tipped is one penny off the 24 pence in the pound rate of standard income tax, still the main tax burden on the middle class Tory voters. Beyond 1997-98, though, Mr Clarke is likely to hold out the carrot of further reductions to 20 pence.

At the same time, the threshold for income tax paid by people on lower incomes may well be reduced from 20 pence to 15 pence in the pound. Personal allowances will be increased providing Mr Clarke with fresh opportunities to curry favour with the various welfare lobbying groups.

Although expected improvements in public finances can meet part of the reduction in direct personal taxation, Mr Clarke will still have to generate increased revenues from elsewhere, probably from indexation of alcohol duties and car taxes. While the 17.5 per cent basic rate of VAT is below the European average, an increase to pay for lower direct taxes would invite criticism and focus attention on the outlook for higher inflation.

Even so, Mr Clarke has substantial scope for widening the VAT tax base through the removal of zero rating from certain categories. As the government found through extension of VAT to domestic fuel VAT is a very hot political potato and to be handled with extreme care. The imposition of VAT on food or children's clothes is therefore most unlikely.

But Mr Clarke could still bridge the fiscal gap by extending VAT to other, less emotive areas of spending. For instance, as much as £1.2 billion could be raised simply by applying the standard rate of VAT to books and newspapers on the premise that the various sectors of the multi media industry need to be treated on a similar basis. Competitiveness and sterling key interests