By Steven Scheer

JERUSALEM (Reuters) - Israel's cabinet on Sunday approved Finance Minister Yuval Steinitz's plan to double the 2013 budget deficit target, defying a warning by the central bank that doing so could lead to eventual interest rate increases.

The budget deficit target next year will be 3 percent of gross domestic product, or close to 30 billion shekels ($7.7 billion) instead of an initially proposed 1.5 percent and a ceiling of 2.5 percent the Bank of Israel had sought.

The deficit target for 2012 is 2 percent but the Finance Ministry expects it to come in closer to 3.5-4 percent of GDP.

"The new deficit targets approved by the cabinet today maintains the fiscal responsibility we have used until now," Steinitz said, adding that it will allow Israel's debt-to-GDP ratio to fall to 60 percent by the end of the decade from 74 percent currently.

Steinitz and Prime Minister Benjamin Netanyahu last week caused a stir among investors when they decided to raise the budget deficit target for 2013.

Initially, officials had said it was instead of raising taxes, sending the shekel to a nearly three year low versus the dollar. But Steinitz later clarified that some taxes would be increased.

Analysts have accused Steinitz and Netanyahu of "election economics" and a reluctance to cut spending and raise taxes ahead of a scheduled general election in October 2013.

Bank of Israel Governor Stanley Fischer warned of higher inflation and higher interest rates if the deficit target was raised, saying loosening the purse strings ran contrary to Israel's needs for tighter policy so that it could weather any deterioration of the global economy, as it did when the crisis first started in 2008.

"Monetary policy cannot sustain low interest rates when fiscal policy is too expansionary," Fischer said at a conference on Thursday.

"I don't expect the monetary policy committee will be able to keep the current level of interest rates if fiscal policy does not get on a sustainable path."

His remarks helped push the shekel to nearly 3.90 per dollar from 3.96.

The MPC last week lowered its benchmark rate to 2.25 percent from 2.5 percent for its first rate cut in five months. Fischer, who did not elaborate on the timing of any potential rate increases, said the government needed to raise taxes.

Prior to the cabinet's vote, Netanyahu told ministers he backed Steinitz's decision to boost the deficit target, arguing that all European countries other than Germany have higher deficit targets.

"This is the right dosage ... It is in the proper measure," Netanyahu said. "We will still need to raise certain taxes and in order to meet the spending target, we will need to do other things and we will do so, and we will meet both the spending target and the deficit target."

He said his views on taxation have not changed since he was finance minister from 2003-2005, when he lowered tax rates.

"When you increase the tax burden you depress growth," Netanyahu said. "And when you depress growth you do two things. You increase unemployment and, in the end, you increase the deficit."

The cabinet also approved Steinitz's proposals to set a 2014 budget deficit target of 2.75 percent in 2014, 2.5 percent in 2015, 2 percent in 2016 and 1.5 percent by 2019.

(Reporting by Steven Scheer; editing by Jason Neely)