By Catherine Hornby
ROME (Reuters) - Italy's cabinet passed a package of measures to trim public spending on Monday, undeterred by a row with Silvio Berlusconi's center-right party that is threatening to bring down the prime minister's coalition and has rattled markets.
The measures included cutting funding for official cars by a fifth, reducing consultancies now valued at 1.2 billion euros per year, and a decree that will gradually convert about 150,000 temporary state administration contracts into permanent ones.
The move followed a meeting between Prime Minister Erico Letta and the secretary of Berlusconi's People of Freedom party (PDL), Angelino Alfano, to seek agreement on a housing tax issue, which has dogged the government for months.
The disagreement, and a looming vote on whether to expel the media mogul from parliament after a tax fraud conviction, have made relations between Letta's center-left Democratic Party (PD) and the PDL increasingly tense.
The spat between the unwilling coalition partners has reignited fears of new political instability in the euro zone's third-largest economy as it struggles to emerge from a two-year recession, sending shares and bonds lower.
The PDL says the tax, known as IMU, must be scrapped despite fears this could blow a hole in Italy's fragile public finances
Alfano said after the meeting that negotiations were ongoing, but an agreement was possible. Letta has set a deadline of a government meeting on Wednesday for an accord.
"There's still work to be done before Wednesday, but we can do it," Alfano said in a tweet. Letta did not comment.
But even if a compromise is reached on the housing tax, the question of Berlusconi's future remains potentially explosive.
A top PD official on Monday accused the PDL of "blackmail" after several of its members threatened to bring down the government if the PD voted to expel Berlusconi from the Senate in a ballot due by October.
"The PD rejects any blackmail or ultimatum from the PDL," PD Secretary Guglielmo Epifani told the daily newspaper La Repubblica on Monday, reaffirming that his party would vote in favor of Berlusconi's removal from parliament.
"Berlusconi needs to take note of what led to his conviction, and he has to explain why he would bring down the government at a time of crisis."
Epifani warned that if the government collapsed just as Italy was showing the first signs of recovery after its longest postwar recession, there would be "enormous costs" for society and renewed tremors in financial markets.
Italy's main stock market index, fell 2.1 percent, with shares in Berlusconi's Mediaset dropping 6.25 percent after hitting its lowest level since July 10. The main index of broader investor sentiment, the spread between Italian 10-year bond yields and their safer German equivalents widened to 249 basis points.
"It doesn't look like the politicians will find a compromise to get out of this crisis, which puts all measures that need to be taken to spur the economy on ice," said a Milan trader.
Letta, appointed to lead the cross-party coalition after inconclusive elections in February, is trying to push on with measures to spur growth and fight record levels of unemployment, but has struggled to pass any meaningful reforms in the face of deep divisions in the government.
Berlusconi's own party is riven by tensions between members pushing for compromise with the PD and those who want to pull the plug on Letta.
On Monday, Berlusconi ordered supporters not to make any further public statements that could damage party unity.
The billionaire has been holed up in his luxury villa near Milan since early August when Italy's supreme court handed him a four-year jail sentence, commuted to one year, for a massive tax fraud at his Mediaset empire.
He is desperately trying to find a way to stay in the political game despite the sentence, which he is expected to start serving, either under house arrest or doing social work, in mid-October.
The supreme court decision is not Berlusconi's only legal headache. He is also appealing in a lower court against a seven-year jail sentence imposed in June for abuse of office and paying for sex with a minor.
(Additional reporting by Steve Scherer, Giuseppe Fonte and Paolo Biondi in Rome, Agnieszka Flak in Milan; Writing by Steve Scherer; Editing by James Mackenzie and Alison Williams)