Falling inflation may encourage the Minister for Finance Mr McCreevy to raise indirect taxes in December's Budget, economists said yesterday.

The annual rate of inflation dropped to 3.1 per cent last month from 3.5 per cent in June, according to figures issued by the Central Statistics Office (CSO). The numbers showed that prices dropped by 0.8 per cent between June and July, with lower mortgage repayments the key driver behind the decline.

Commentators believe the economy is now facing into a sustained fall in inflation and are predicting that the annual rate could fall below 2.5 per cent before the end of the year.

This would translate into a 2003 average of less than 4 per cent, significantly below the 4.8 per cent envisaged by the Department of Finance last December.

As inflation falls towards less worrying levels, the Minister for Finance could be presented with space to raise indirect taxes in his forthcoming Budget, according to Friends First chief economist, Mr Jim Power.

Mr Power said inflation "has become yesterday's story", seeing the ongoing moderation as a potential opportunity for the Minister for Finance to raise extra revenue through taxation.

Mr Austin Hughes, chief economist with IIB Bank, pointed out that such an outcome was becoming increasingly likely as the downward move in price growth eats into the Republic's tax revenues.

He said the difference between the Government's forecast for inflation in 2003 and the probable outcome could translate into a taxation revenue gap of up to €150 million as wage growth slows and the tax base becomes smaller than expected.

The effect could be "potentially much larger" depending on how private sector employers respond to the fall in inflation, Mr Hughes warned.

The Department of Finance said that, at the end of June, taxation revenues were likely to come in €500 million below initial targets for the year.

"One of the key issues facing the Irish economy in the next few months is how the Government responds to the wider gap in its finances that is at least in part due to lower inflation," Mr Hughes said.

The "evidence" of recent years suggests that hikes in public-sector charges and indirect taxes are likely, he believes.

He urged caution on such measures, however, pointing out that Government-linked price increases will, in turn, drive up the 2004 inflation rate.

Inflation for 2003 continues to be a two-track story, with persistent pockets of domestic price pressures overshadowed in the past few months by a downward trend in global inflation.

Detailed figures contained within yesterday's consumer price index release show that the price paid by Irish consumers for services continue to rise out of sync with other charges.

The cost of services such as water supply and rubbish collection has, for example, risen by almost 20 per cent over the past year.