By Gavin Jones
ROME (Reuters) - Italy's economy will contract by more than expected this year and its public finances will deteriorate in 2013 and 2014, the Organisation for Economic Cooperation and Development said on Thursday.
The OECD's 122 page Economic Survey of Italy, which said Rome's fiscal deficit will exceed European Union limits this year and next, underlined the tough challenges faced by Enrico Letta's new government which took office last week.
The euro zone's third largest economy will shrink by 1.5 percent in 2013, compared with a forecast of a 1.0 percent fall in output made in November, the Paris-based institute said. It projected anemic growth of 0.5 percent in 2014.
"Fiscal consolidation, declining investment and the rebuilding of household savings, along with tight credit conditions, are likely to hold back growth in coming months," the report said.
All the OECD's main economic and public finance forecasts were more negative than the official targets that Letta has inherited from former Prime Minister Mario Monti.
Despite waves of austerity adopted by Monti's government, Italy's huge public debt will rise to a new record of 131.5 percent of output this year, the OECD said.
In 2014 debt will climb further to 134.2 percent, rather than fall to 129 percent as envisaged by Rome's targets.
Italy has the euro zone's second-largest debt after Greece as a percentage of gross domestic product. When Monti took office in 2011, the debt stood at 120.8 percent of GDP.
Italy must reverse this upward debt trend, the OECD said, "either with a balanced budget or small fiscal surplus, supported by strong implementation of growth-enhancing structural reforms."
However, Italy's progress towards a balanced budget has also come to a halt, according to the OECD's forecasts.
It said the budget deficit will rise to 3.3 percent of output this year, above the EU's 3 percent limit and compared with Rome's 2.9 percent target.
The deficit would reach 3.8 percent in 2014, more than twice the official target of 1.8 percent, the OECD projected.
Several members of Letta's left-right coalition government have urged him to try to re-negotiate Italy's public finance commitments with the European Union, saying the country needs to cut taxes and spend more to stimulate the economy.
The OECD urged Italy to consolidate its finances through spending curbs rather than higher taxes and to strengthen previous efforts by Monti to tackle corruption.
It said Italy needed to better align wages with productivity to help restore competitiveness, and called for further reform of the labor market, welfare and the justice system.
(Reporting by Gavin Jones; editing by James Mackenzie)