Chancellor George Osborne increased VAT from 17.5% to 20% and cut welfare spending as he moved "decisively" to tackle Britain's record debts.
Child benefit and public sector pay will be frozen and 25% cut from public service spending - but alcohol, tobacco and fuel will escape tax hikes.
Unveiling his first Budget to MPs, Mr Osborne said "tough but fair" action on debt was "unavoidable".
But Labour said it was "reckless" and would "throw people out of work".
Acting Labour leader Harriet Harman said Mr Osborne's budget would stifle growth and hit hardest "those who can least afford it".
BBC Political Editor Nick Robinson described the financial statement as a "massive gamble economically and politically".
It represents a major departure from the previous government's economic policies, with business leaders saying they hoped it would be a "defining moment" in Britain's economic recovery.
But trade unions have warned hundreds of thousand of jobs could be lost in the public services, potentially wrecking local economies and sparking a "double-dip" recession.
Setting out his plans in the Commons, Mr Osborne said "decisive" action was needed to prevent a "catastrophic collapse" in economic confidence but stressed it would be done in a "fair" way with the better-off shouldering most of the burden.
"Everyone will pay something but the people at the bottom of the income scale will pay proportionately less than those at the top. This is a progressive Budget," he said to jeers from Labour MPs.
UK households, on average, will be about £400 a year worse off, Budget documents suggest, with the poorest 10% losing £200 and the richest £1,800, although the poorest will be hit harder than most as a percentage of their income.
Mr Osborne vowed to balance Britain's books within five years, with the bulk of the savings to come from cuts to benefits and public services rather than tax increases.
And he laid the blame for the state of the nation's finances squarely at the door of the previous Labour government, saying: "The years of debt and spending make this unavoidable."
Tax credits will be cut for families earning more than £40,000 a year - and there will be a two year pay freeze for public servants paid more than £21,000. Those earning less will get a £250 rise for two years.
Mr Osborne also announced real terms cuts across all government departments of 25% over four years - except health and foreign aid which are ringfenced.
Will Hutton, of the Work Foundation, who is advising the government on public sector pay, described the cuts as "brutal" and questioned whether they were achievable without wrecking the coalition government.
He described Mr Osborne's Budget as the "biggest gamble a post-war government has made".
The full details of the impact of the cuts will not be revealed until Wednesday 20 October, when Mr Osborne publishes his spending review.
The VAT increase, which Mr Osborne said would raise £13bn a year, is to come into effect in January.
Capital gains tax will be increased to 28% for top rate taxpayers - less than the 50% some Conservative backbenchers had feared. This will come into effect at midnight.
In other moves, Mr Osborne pledged to pledge to link pensions to earnings - or prices or 2.5% if they are higher.
Housing benefit will be reformed with a maximum limit of £400 a week, in a package saving £1.8bn a year by the end of the Parliament.
Other benefits to be cut include the health in pregnancy grant while the Sure Start maternity grant will be restricted to the first child only and lone parents will be expected to look for work when their youngest child goes to school.
But there will be an extra £150 a year for the poorest families, through changes to family tax credits.
The government is also to introduce a medical assessment for Disability Living Allowance from 2013 for new and existing claimants.
Mr Osborne also announced plans to help the low paid by raising personal tax allowances, taking an estimated 880,000 people out of the tax system and give millions of basic rate taxpayers a tax cut of £200 per year.
From January 2011, the government will introduce a bank levy, which will apply to the balance sheets of UK banks and building societies and the UK operations of foreign banks. Mr Osborne said the move would raise £2bn a year once it was fully in place.
Mr Osborne said public sector workers paid more than £21,000 a year would have a two year pay freeze with those paid less getting a flat pay increase of £250 for the next two years.
The plan is the first step towards a key Liberal Democrat coalition demand of taking all those earning less than £10,000 out of tax.
The chancellor must find £3.5bn to pay for the giveaway - which will be clawed back from top rate taxpayers - and Labour are likely to argue it is irresponsible in the current climate.
Mr Osborne also froze the Civil List payments to the Royal Family at £7.9m a year and said in future years they would be subject to scrutiny by the National Audit Office.
He stressed that the pain of his austerity measures would be shared by "everyone" - but said all would share in the proceeds of the "enterprise-led recovery" that he promised would follow.
"Yes it is tough, but it also fair," said Mr Osborne of his first budget, adding: "Everyone will share in the rewards when we succeed. When we say that we are all in this together, we mean it."
He said that the Office for Budget Responsibility (OBR) now estimated growth this year of 1.2% and 2.3% next year - compared to its previous forecasts of 1.3% of 2.6%.
Giving her response to Mr Osborne's statement, acting Labour leader Harriet Harman poured scorn on the Liberal Democrats for providing a "fig leaf" for their Conservative coalition partners, arguing "this reckless Tory budget would not be possible without the Lib Dems".
"The Lib Dems leaders have sacrificed everything they ever stood for to ride in ministerial cars and to ride on the coat tails of the Tory government," she added.
Plaid Cymru also lashed out at the Lib Dems, with Treasury spokesman Jonathan Edwards accusing party leader and Deputy Prime Minister Nick Clegg of sitting next to Tory leader David Cameron "like a nodding dog, agreeing with every word as VAT was raised".
"They are running out of major election policies on which to U-turn," he added.
The SNP welcomed some Budget measures, such as the freeze on whisky duty and the restoration of the pensions and earnings link, but branded planned spending cuts "irresponsible".
In a message to Liberal Democrat supporters, Deputy Prime Minister Nick Clegg said the government had "no choice except to clear up the financial mess that Labour left us".
And he said the Budget had taken "difficult decisions in an honest and fair way and with the clear stamp of Liberal Democrat values running through it," citing examples including the restoration of the pensions and earnings link and the tax boost for the low paid.
Lib Dem Deputy Leader Simon Hughes, who has vowed to protect the party's core values, issued a statement in support of Mr Clegg after the Budget statement, saying it would protect the "needy and vulnerable".
So far only one Lib Dem MP, Bob Russell, has publicly suggested he might vote against the Budget, as the party had campaigned against VAT increases at the election because "the low paid disproportionately pay more".
He told BBC Radio 5 Live: "I am not at all happy. I need to discuss with colleagues how it is we have got into this situation."
Dave Prentis, general secretary of public service union Unison accused the coalition government of "declaring war" on public services, saying the Budget would "raise the spectre of breadline Britain" in some parts of the country.
"Public sector workers will be shocked and angry that they are the innocent victims of job cuts and pay freezes".
But CBI director general Richard Lambert called the Budget "the UK's first important step on the long journey back to economic health".
Green MP Caroline Lucas called Mr Osborne's statement a "budget for pointless austerity" full of cuts that were "neither unavoidable or fair".
But in an e-mail to Conservative supporters, Prime Minister David Cameron said: "In this emergency Budget I believe you have the measure of this government.
"Will it provoke debate? Certainly. Will it cost our coalition some popularity? Possibly. But is this the right thing to do - for the health of our economy, for the poorest in our society, for the future of our country? I passionately believe it is."