Mr Osborne said there would be a "trade-off" which could see savings in the multibillion-pound benefit bill used to cushion the impact of cuts of as much as 25% in budgets for public services like the police, defence and schools.

He named Housing Benefit and Employment and Support Allowance - which replaced Incapacity Benefit for people with long-term health problems - as areas where the axe may be wielded.

Mr Osborne stressed that any reforms would protect the disabled and those in "genuine need", but would aim to encourage those who are able to work to get off benefits and into employment.

Some 2.6 million people claim ESA or Incapacity Benefit at a cost of around £12.5 billion annually while Housing Benefit pays out about £21 billion a year. These figures make the benefits bigger drains on taxpayers' money than many Whitehall spending departments, pointed out Mr Osborne.

Ministers have been told to look for ways of reducing the welfare bill over the summer, in time for details to be unveiled in the Spending Review on October 20.

Any savings could be used to reduce the level of cuts needed in departments like education and defence, which were not protected by a "ring-fence" in last week's Budget.

But Mr Osborne said he would not rethink his decision to ring-fence the health budget and deliver real-terms annual increases to the NHS, which has the knock-on effect of heightening the pain in other areas of public spending.

The Chancellor said he wanted a genuine public debate over the summer about how Government spending can best be reined in.

Speaking to reporters at the G20 summit in Toronto, Canada, Mr Osborne said: "There is a real trade-off. It is a choice we all face and it is not a choice that can be ducked. Of course, we have got to look across the piece at the welfare bill, and of course we have got to look at individual benefits."