Targeted VAT cuts are needed to boost growth in key sectors of the economy, the Federation of Small Businesses (FSB) has said.
Its call comes after its latest survey of confidence among the UK's small firms reported a big drop in sentiment during the three months to 30 June.
The Treasury said a cut would have an adverse impact on government finances.
Meanwhile, the Ernst & Young Item Club has cut its economic growth forecast for the UK for 2011 from 1.8% to 1.4%.
The group also lowered its growth prediction for 2012 from 2.3% to 2.2%, as it warned that the UK is at a "critical juncture".
The Item Club said that unresolved worries about the global economy, with Greece a major threat to the financial system and the Republic of Ireland a particular worry to UK banks, were likely to hold back UK business investment.
Professor Peter Spencer, the Item Club's chief economic adviser, said its downgrade was mainly due to the squeeze on household income.
"You might not notice the 0.5% but you certainly notice that the economy is very weak, and furthermore all of that growth is coming from the export side," he told BBC Radio 4's Today programme.
"So the home market is being crushed by a situation where prices keep on inexorably going up and of course people can't get the wage increases to offset that. so if you're a consumer it feels bad."
The FSB's Voice of Small Business Index fell by 6.4 points to +0.3 from +6.7 in the first quarter.
The index has a median level of zero points, which represents no change in confidence from the previous quarter. The higher the positive points score, the more confident firms are on average across the UK.
The FSB is urging VAT be cut to 5% in the construction and tourism sectors.
"Consumer demand is a key barrier to economic growth so such a cut would encourage people to spend in these areas," the FSB said in its Voices of Small Business Report.
The survey, which interviewed 1,633 small business owners across the UK, found that confidence had fallen in 13 of the 18 sectors it monitors.
The least confident companies were those that sell or repair motor vehicles, with an index score of -45.
This sector also posted the biggest decline in sentiment, as it compares with a +20 result for the first three months of 2011.
For the two sectors that the FSB would like to see a VAT cut, tourism (hotels, restaurants, bars and catering) saw confidence fall to -4 points from +13.
The construction sector rose from +2 to +3.
The survey found that the most confident sectors of the economy include manufacturing, the computer industry, and financial services.
The FSB said: "Evidence from other EU countries shows that any lost revenue to the Exchequer by making VAT cuts will be met by earnings from additional demand, jobs and the wider economic activity."
Across the nations and regions of the UK, confidence only rose in two areas - the east of England and the East Midlands - which the FSB said was due to "the resurgence in manufacturing".
The biggest fall in confidence was in the north east of England.
John Walker, FSB national chairman, said: "The economy is still in a fragile state and these figures clearly show that the government's growth strategy is just not working.
"In an economy characterised by high unemployment and muted demand, more needs to be done to encourage businesses to take on staff and grow their business so that the recovery can really get back on track."
A Treasury spokesperson said: "Reduced VAT rates of the kind suggested would make a significant impact on revenue.
"Any claim that a boost to foreign tourism or construction would outweigh these effects would need to be looked at very carefully indeed."