By James Mackenzie
ROME (Reuters) - Prime Minister Enrico Letta told critics of his 2014 budget on Friday that Italy still needed to demonstrate its credibility to wary financial markets, rejecting calls for steeper tax cuts and more measures to stimulate growth.
Speaking as the lower house of parliament in Rome passed a procedural confidence motion on the budget, Letta said the government had done all it could to help investment while maintaining control of public finances.
"We and Europe are both still under observation," he told reporters in Brussels where he was attending a summit of European Union leaders. "We absolutely have to maintain the same care that the father of a family does. I say that to everyone in Italy who wants Father Christmas instead."
"We have to make balanced choices that keep us credible in Europe," he said.
The lower house of parliament passed the confidence motion, a standard measure used to speed legislation, ahead of a separate vote to approve the package later in the day. The Senate is due to complete parliamentary approval on Monday.
The budget, which keeps Italy's public deficit just within the European Union's ceiling of 3 percent of gross domestic product this year, trims some taxes on employment and replaces the hated IMU housing levy.
But it has been widely criticized for not doing enough to cut spending and help growth.
Letta's coalition, based around the center-left Democratic Party and a smaller center-right group led by Interior Minister Angelino Alfano, is more confident of being able to pass reforms since a break with former Prime Minister Silvio Berlusconi, who quit the government last month.
But it faces a huge challenge in turning around an economy which has shrunk by more than 9 percent since 2007, with youth unemployment running at over 40 percent and an industrial infrastructure which has crumbled during the crisis.
The mildly expansionary budget makes minor adjustments to current spending and revenue trends, but with the government determined to banish any doubts about the solidity of public finances, its room for maneuver has been severely limited.
Confindustria, Italy's main business lobby, has been particularly critical of the government's failure to act more decisively to cut the so-called "tax wedge" - the difference between employers' labor costs and a worker's take home pay.
"It's not what we were expecting and it's not enough to get the country going again," the lobby's president, Giorgio Squinzi, said this week.
The budget foresees a reduction in the tax wedge of just over 2.5 billion euros ($3.42 billion) in 2014 and 3 billion in 2015, which it intends to fund partly out of spending cuts, well short of Confindustria's call for 10 billion euros in tax cuts.
However there has already been growing concern that resources originally earmarked to balance tax cuts may be diverted to fund urgent spending priorities such as unemployment benefit funds.
"I think there have probably been excessive expectations about our ability to concentrate resources, which are not enormous, on strategic objectives such as the reduction of the tax wedge," Economy Minister Fabrizio Saccomanni told RAI radio.
The government expects Italy's budget deficit to fall to 2.5 percent of output in 2014 from a targeted 3.0 percent this year, on the assumption that the economy grows by 1.1 percent.
That growth forecast is widely considered optimistic and the public debt is seen rising to almost 133 percent of output this year and next, second only to Greece's in the euro zone.
The European Commission said failure to ensure satisfactory debt reduction meant Italy was not eligible for budget leeway to increase investments, something Rome had hoped for.
The budget envisages some 4 billion euros in spending cuts and 7.3 billion euros in additional revenues this year, set against 13.9 billion euros in new spending commitments, leaving a fiscal gap of some 2.6 billion euros.
In addition to the tax wedge cut, the IMU tax on primary residences will be replaced by a new tax on municipal services which will go towards funding cash-strapped local authorities.
Sales of publicly owned buildings are expected to raise 1.5 billion euros over three years, while top pensions will be held back and a series of tax breaks will be reorganized. But a spending review under former International Monetary Fund official Carlo Cottarelli, expected to bring 11.3 billion euros of cuts by 2017, will not begin to produce results until 2015.
One source of extra income that has been contested in Italy and abroad is a tax aimed at raising revenue from online multinationals which currently pay their levies in low-tax countries like Luxembourg, Ireland or outside the EU.
Letta said the measure would require coordination with other European countries which he expected would come this spring.
($1 = 0.7316 euros)
(Additional reporting by Giuseppe Fonte Editing by Jeremy Gaunt.)