By Simon Johnson and Johan Ahlander
STOCKHOLM (Reuters) - Sweden's center-right government bet on a new round of income tax cuts in its 2014 budget on Wednesday to boost growth and win it a third term in office in elections next year.
The ruling four-party Alliance came to power in 2006 promising to shore up Sweden's welfare model by encouraging more people to work, mainly through income tax cuts. They made the same promises in 2010, when they were returned to power.
But three years on, unemployment remains high, the economy is still sluggish and the government is lagging in the polls.
Despite a soft economy, the central bank is unlikely to improve voters' mood by cutting interest rates because it is worried about high levels of household debt.
That leaves the government's 24 billion Swedish crown ($3.7 billion) budget package of income tax cuts and job measures to create a feel-good factor by September next year when the election is due.
"Sweden has among the strongest public finances in Europe," Finance Minister Anders Borg said. "So now we should use that position to limit the risk that unemployment becomes entrenched."
Government debt, at around 36 percent of gross domestic product (GDP), is among the lowest of major countries in Europe, allowing room to stimulate the economy.
But household debt levels at around 170 percent of disposable income are among the highest in Europe, leaving many who have borrowed against the value of their homes at acute risk should house prices fall sharply.
Boosting incomes could lead to households borrowing more rather than less and on Wednesday, the central bank warned that lending had picked up pace in the summer.
"The Riksbank cannot ignore this," Governor Stefan Ingves said in the minutes of the Riksbank's last policy meeting.
The Riksbank's tough talk helped the crown strengthen to around 8.62 to the euro from 8.65 at 5:29 a.m. ET.
The government has already capped the amount mortgage-takers can borrow and raised the amount banks need to set aside against the risk of defaults.
But authorities can't move too fast or they risk squeezing spending. Many Swedes pay only the interest on their loans but on the question of making mortgage repayment compulsory, Borg said: "I don't think it is really on the agenda. There are other measures that are more suitable."
Underlining the fragile nature of Sweden's recovery, Borg said the economy could undershoot current forecasts of growth of 1.2 percent this year and 2.5 percent in 2014.
GDP rose by 0.7 percent in 2012.
The government hopes a fifth round of income tax cuts will be the trump card in the election, due by September 2014.
"The budget is an attempt to make taxes ... one of the main themes of the election," said Peter Esaiasson, professor of political science at Gothenburg University.
"More than anything, it's a way to try and make the Social Democrats look like they are a party of tax hikes."
With opinion polls this month showing the Alliance with around 39 percent support and the opposition bloc, led by the left-of-center Social Democrats, at 49 percent, voters appear more concerned with other issues.
Unemployment is expected to be around 8 percent this year - higher than the 7.1 percent registered in 2006 - and Swedes are suspicious of more welfare cuts after scandals over private care homes for the elderly and for-profit schools.
The major measures in the budget were already known. The cuts in income tax rates will cost around 12 billion crowns and a hike in an income threshold will cost another 3 billion.
The budget also had tax cuts for pensioners, lower unemployment insurance costs, measures to get boost youth employment and a boost to teachers' wages.
The state budget watchdog has said the budget measures mean the government would have to raise taxes eventually to achieve its target of a 1 percent surplus in public finances over a business cycle.
($1 = 6.4903 Swedish crowns)
(Additional reporting by Johan Sennero; editing by Patrick Graham/Ruth Pitchford)