Economic volatility could increase if Britain enters the eurozone, one of the Treasury's background studies has suggested.

A discussion paper described interest rates as the main mechanism for managing demand in the British economy, with the Treasury's fiscal rules also "smoothing the path of the economy" over the cycle.

With interest rates transferred to the European Central Bank, the government could be forced to use other means to manage the economy.

The "fiscal stabilisation and EMU" report suggests the government could adopt a policy of using tax and spend measures to balance the British economy, pledging to take action if the forecast output gap rises to plus or minus one to 1.5 per cent of GDP.

The move could be accompanied by enhanced independent monitoring because of "the complexities of operating a more active fiscal stabilisation policy".

Rates of VAT and duty could be varied outside the Budget process.

But direct taxes such as income tax and National Insurance are described as likely to generate "significant problems" if used to stabilise the economy.

Similar problems are identified with a possible consumer credit tax and tax credits for investment are also thought to be of questionable effectiveness.

The report finds that housing taxes such as stamp duty and expenditure taxes, primarily VAT, are most likely to prove effective in regulating the economy.

Changes to expenditure taxes "could prove useful instruments with limited undesirable impacts on incentives, the supply side or the overall equity of the system", says the study.

"The Treasury will conduct further analysis into these issues to ensure the policy proposals would deliver effective counter-cyclical stabilisation of the economy were the UK to join EMU."