By Deepa Babington and Giuseppe Fonte
ROME (Reuters) - Prime Minister Silvio Berlusconi's main coalition ally on Tuesday warned the government could collapse over an unpopular austerity plan.
The 43 billion euro ($61 billion) plan, seen by economists as vital to avoid contagion from Greece's debt crisis, is Berlusconi's biggest test since suffering two major political defeats and has raised tensions within the ruling coalition.
The Northern League, the pro-devolution government member led by Umberto Bossi, opposes budget plans to cut funding to local governments and pension spending, putting it at odds with Economy Minister Giulio Tremonti.
Tremonti on Tuesday denied newspaper reports that he had threatened to resign if his austerity plan was changed. He is widely credited with protecting Italy from the global economic crisis by insisting on prudent fiscal policies.
Berlusconi met coalition leaders on Tuesday at his private residence in Rome to thrash out agreement on the plan. Asked by reporters ahead of the meeting if the government risked falling over the budget, Bossi said: "Yes."
Markets and ratings agencies are watching closely for any signs of backsliding on the package, which is aimed at eliminating the budget deficit in 2014.
Moody's and Standard & Poor's have warned they may cut Italy's credit rating because of its decade-long inability to stimulate growth and reduce its debt mountain, which at 120 percent of gross domestic product is one of the world's biggest.
Economy ministry sources said the package will be worth some 43 billion euros, with the bulk of the savings expected in the 2013-2014 period. It will include cuts to ministry budgets as well as spending on local councils and health care.
A public sector hiring and salary freeze will be extended and pension spending may be curbed, the sources say.
The League and some members of the government fear the budget will further reduce support for the coalition partners.
Italy's budget deficit is targeted at 3.9 percent of gross domestic product this year, down from 4.6 percent in 2010.
Tension bubbling within the coalition over the budget erupted on Sunday when a senior coalition member accused Tremonti of trying to cause the government's collapse.
Defense Undersecretary Guido Crosetto said he was "fed up" with Tremonti's autocratic style, saying he was imposing indiscriminate cuts on every ministry but his own.
Berlusconi, who has suffered stinging defeats in mayoral elections and four referendums in the last month, needs the support of the League to remain in power but has also promised to back Tremonti's tight rein on public finances.
Relations have been strained for months between Berlusconi and Tremonti, who is considered a contender to succeed the media magnate at the helm of the center-right in the future.
(Editing by Barry Moody and Sonya Hepinstall)