Italy's fiscal boost faces tough questions from EU and ECB

ROME (Reuters) - Italian Prime Minister Matteo Renzi could struggle to convince the European Union that his ambitious tax cuts and spending commitments will not threaten pledges to sort out public finances.

On Wednesday, the 39-year-old former mayor of Florence announced income tax would be cut by 10 billion euros (8 billion pounds) annually for 10 million low- and middle-income workers from May 1 to try to stimulate a chronically sluggish economy.

In a typically buoyant, informal news conference involving slogans and Powerpoint slides, Renzi also promised to cut a regional business tax, reduce company energy bills and pay off the entire arrears of commercial debt owed by public sector bodies by July.

The problem for Renzi is how to pay for the promises, given European institutions' apparent impatience with Italy's inability to cut the second highest public debt in the euro zone, at around 133 percent of gross domestic product (GDP).

"This year we are putting into place the spending reductions that will finance our tax cuts on a permanent basis; this is sound economics," Filippo Taddei, economics spokesman for Renzi's Democratic Party, told Reuters in an interview.

With euro bond markets currently favouring higher-yielding debt, Italy sold all of a planned 7.75 billion euros of government paper on Thursday, paying record low yields on three year and 15-year bonds.

The European Commission and the European Central Bank were more cautious. "We recall that Italy has to respect its commitments under the stability and growth pact, especially in view of its very high public debt," Commission spokesman Simon O'Connor told a briefing in Brussels.

OUTSIDER

It is easy to get the impression that the Commission is less indulgent towards Renzi, who cultivates his image as an outsider, than it was towards his predecessors Enrico Letta and Mario Monti, both seen as more orthodox, institutional figures.

Last week the Commission put Italy, one of the EU's founding members, on a watch list alongside the ex-Yugoslav economies of Slovenia and Croatia, citing its weak productivity and unwieldy debt. It took Spain off the list, noting its recent reform efforts.

On Thursday the ECB said in its monthly bulletin, albeit written before Renzi's tax plan, that Italy had made "no tangible progress" since November in cutting its deficit and debt.

Renzi's team of mostly young ministers and economic advisers are convinced Europe will cut them some slack when it realises how serious the government is about making permanent spending cuts and spurring productivity.

"The ECB is waiting for tangible measures and that is what we are trying to propose now," said Taddei, 37, who teaches economics at Johns Hopkins University in Bologna.

"The problem Italy has is growth, not fiscal prudence," Taddei said, pointing out that Rome's budget surplus net of debt servicing costs is already among the highest in the EU.

"We will keep on being prudent but we have to address the issue of growth."

Cabinet Undersecretary Graziano Delrio also stressed that Italy's debt-to-GDP problem was "all about the growth part of the equation, not the debt part."

BACKTRACKING?

Renzi said his tax cuts would be financed by reductions in central government spending, extra borrowing and resources freed up by the recent fall in Italy's borrowing costs.

He made clear the current 2014 deficit target of 2.5 percent of GDP would be raised, while remaining below the EU's 3 percent ceiling.

Some analysts said he was backtracking on previous promises that any tax cuts would be entirely financed by lower spending.

But Taddei said structural spending cuts needed some time to be fully effective while the tax cuts would hit public accounts straight away. A little extra borrowing and use of the dividend from lower bond yields would be a temporary cushion.

Renzi will also need European approval for his plans to use the state holding company Cassa Depositi e Prestiti (CDP) as an agent to pay off some 43 billion euros of commercial arrears owed by the state to private suppliers.

The CDP will pay off the cash-starved companies immediately, while the government will then pay back the CDP gradually over coming years, Taddei explained.

This will spread out the inevitable increase in public debt, which is only booked when bonds are issued by the state to reimburse the CDP.

Taddei said he believed the scheme had already been discussed with EU authorities and he was confident of EU support. "I think the Commission will be open to what we are proposing if they understand that what we are doing will have a permanent, not a transitory effect on the economy," he said.

(Additional reporting by Valentina Za, Francesca Landini, Francesco Guarascio, James Mackenzie; Editing by Ruth Pitchford)