The most important political lesson of the Coalition's Budget is its confirmation of the dominance of Conservative Centre-Right positions within the Coalition on economic and fiscal policy. We already knew from the negotiations that led to it, and subsequent announcements of £6 billion of cuts in 2010/11, that the Liberal Democrats had shifted ground out of the broadly Keynesian camp in which they had fought the election and realigned themselves with conservative advocates of fiscal retrenchment.  Now the Coalition has gone further and faster on deficit reduction, at an explicit cost to jobs (at least 100,000 a year more will be lost as a consequence of yesterday’s Budget and doubtless more, given the scale of the shake out in the public sector that is starting to take place) and to weaker growth in the immediate years ahead.

The Budget entrenches this ideological realignment by following it through into wider tax and spending decisions. Fiscal consolidation will be borne largely by steep spending cuts, rather than tax rises, in a 77:23 ratio - very close to the Conservative’s preferred split of 80:20. The distributional impact of such a ratio will necessarily be regressive, given the relative bias towards low income families of public spending and social security benefits. Meanwhile, the neo-liberal model of economic growth – such as it now is – of cutting taxes on business whilst cutting the state is reasserted as the foundation of dynamism and prosperity. The role of public services in supporting growth, and of an intelligent state capable of fostering broadly based, strategic and productive investment, was largely derided yesterday, save for capital investment in transport infrastructure.

Tellingly, the central Liberal Democrat election commitment to fairness in taxes and benefits has been abandoned. A few facts illustrate this simply enough. In their Manifesto, the Liberal Democrats promised to raise nearly £2 billion from Capital Gains Tax reform. The Budget secures less than half that (£925 million). In addition, they pledged to raise £5,455 billion by restricting tax relief on pension contributions to the basic rate. This highly progressive measure has now been completely dropped. Ditto the Mansion Tax on properties worth over £2 million, due to have raised £1.7 billion. And there was barely a mention of the green taxes they had pencilled in to raise over £3 billion in the Budget. On almost every score, their pre-election tax package has been stripped of its progressive content.

Raising personal tax allowances by £1,000 a year helps the working poor who earn enough to pass the current threshold of £6,475 a year, but not the unemployed, the inactive or those who already earn too little to pay any tax. The majority of the nearly £4 billion of this tax cut goes to middle income basic rate taxpayers, not the lowest earners. And whilst re-indexing the Basic State Pension to earnings from 2011 is desirable (and based on a wider post-Turner consensus on pensions reform), the measure had already been factored into the Treasury’s costings from 2012 onwards during Labour’s last years in office.

In fact, if you look at the widely touted distributional impact tables in the Red Book. (Annex A, page 63), you see that all the heavy lifting on progressive taxation is done by reforms introduced by the previous Labour government, not by yesterday’s Budget (the black bar in chart A2,  for the top decile). The poor lose primarily by the increase in VAT. The middle classes lose tax credits and pay more VAT. And the better off lose from direct tax and National Insurance changes inherited from Labour – almost nothing at all from anything agreed by the Coalition. Moreover, as Alex Barker points out in the FT,  these tables do not include the full impact of benefit cuts, since these are not felt until after 2012/13.

It is simply incredible to call this “fair”. Inequality will almost certainly increase as a result of the Budget, since as Labour found to its cost, even the most progressive tax and spending reforms swim against the tide of rising inequality in today’s economy and barely constrain its growth, let alone reduce it. True, child poverty may not worsen, since the Chancellor’s decided to increase the child element of the tax credit, but it will not fall, making the goal of abolishing it by 2020 an even more remote prospect. And the overall story of this Budget is one of generational injustice, with cuts falling on working age families and those with children, but not the asset rich pensioner population. David Willetts’ warnings have been not been heeded.

To claim the historic mantle of a “progressive alliance” for this Budget, as the Chancellor did, is mere chutzpah from a Conservative. For many Liberal Democrats, it will be a more painful and telling reminder that the progressive 20th century liberal tradition of the People’s Budget, Beveridge and Keynes has been displaced in economic policy by the older, classical variety. This is a major change in the constellation of British politics.

Where does that leave the Liberal Democrat leadership? To assuage its grassroots, even greater political weight will now have to be carried by the programme of democratic and constitutional reform to which it is committed. In this it should have Labour’s full support, as long as the party can overcome its own conservatism on these issues. The big question is how far the Conservative Right and its grassroots mobilise to oppose it (on which the signs are ominous) and whether Cameron chooses to constrain them to shore up his partners.

But this autumn’s Spending Review is going to be a bloodbath and it will put immense pressure on Clegg, not least because local government spending is now directly in the firing line. If the NHS and International Development are protected at flat real terms increases, and education and defence get more lenient treatment than the 25% average departmental cuts implied by today’s announcements, then local government services will bear the brunt, with major cuts in social care, children’s services and regeneration. Housing will almost certainly suffer badly too, particularly if transport infrastructure is not cut by the full 50 per cent implied by the capital investment settlement. That will mean fewer social and affordable homes to rent or buy, repeating the costly errors of both previous Labour and Conservative governments.

Indeed, yesterday’s Budget cuts to Housing Benefit are a sideshow to the big issue in housing, which is that spending has shifted dramatically towards supporting individuals with housing costs - rather than investing in bricks and mortar over the last twenty or so years since rent controls were abolished and local authorities were made to stop building council houses. As a country, we simply invest too little in building the homes our people need, whilst allowing asset prices to inflate beyond the reach of ordinary families.

What should Labour do in response to all this? Rightly, it has opposed the severity of the new deficit reduction path, and the cost to growth and jobs it implies, as well as the regressive impact of the increase in VAT. But this kind of opposition cannot last a full Parliament, and history tells us that when the headline rate of VAT goes up, it doesn’t come down, whoever wins the following election. Nor can the new Labour leader avoid hard choices on fiscal priorities, and which cuts to accept, as well as to oppose, this autumn. Retreating to occupy the space of defender of the public sector and its staff is political suicide in the long run.

Instead, Labour needs to define and defend what can be described as a new ‘social democratic majoritarianism’ (although it will need a better name to win the support I’m seeking to describe). The long run affordability of the welfare state depends above all else on a broad tax base generated by full employment of people of working age, which in turn is dependent on collective services for caring for children, the disabled and the elderly, enabling men and women to work as they want.  Labour should prioritise comprehensive childcare and social care services, insisting on their centrality to a just and dynamic society with an ageing population. Giving everyone a stake in these services will cement political support for them, just as universal benefits, such as Child Benefit and the Basic State Pension, have survived retrenchment.

At the same time, Labour needs urgently to develop a new economic model. As Liam Byrne and others have rightly pointed out, Labour was punished at the last General Election by low and semi-skilled workers – waged and self-employed – who saw their real incomes stagnate or fall in the last Parliament as productivity gains were retained by employers, immigration brought stiffer job competition, and the social wage got absorbed into schools and hospitals, rather than passed back in social and affordable housing that directly benefits individual families. Their support will only return if the economy provides them with decent, well paid jobs that offer security and prosperity, which requires a hard-headed assessment of the weaknesses of the pedestrian, laggard sectors of the UK economy and the failure of skills and innovation policy to shift their performance of the last decade. Similarly, inequality and poverty will only be reduced if work is shared more fairly across households, with increased labour force participation made possible for low income families by affordable or free care services, supported by active welfare measures.

These are broad strokes. But the Budget shows that if Labour can define a new social democratic programme that is at once more liberal, pluralist and democratic - respecting the individual citizen with a state that works for them – and above all more egalitarian than was New Labour, then the ideological realignment currently taking place on the twin axes of economic policy and political reform will open up genuinely new territory for the left.

Nicholas Pearce is former head of the Number 10 Policy Unit.