Italy's divided coalition to seek to plug budget hole on Friday

By Gavin Jones ROME (Reuters) - Italy's fractious coalition government will try to work out on Friday how to avert a planned rise in sales tax while reining in a budget deficit which is overshooting European Union limits. Silvio Berlusconi's People of Freedom party (PDL), a key partner in Enrico Letta's fragile left-right coalition, has threatened to bring down the government unless it abandons the sales tax hike, due to take effect in October. The government needs to find measures worth 1 billion euros ($1.35 billion) to suspend the increase for three months and at least another 2 billion to bring the deficit inside the EU ceiling of 3 percent of output before the end of the year. An increase in excise duties, a cut in spending allocations to ministries and a delay in the scheduled payments of overdue bills to private suppliers are among the measures to be discussed, government officials have told Reuters. The cabinet meeting has been called for Friday but no exact time has been given for its start, a government official said. The government is targeting the deficit to fall to 2.9 percent of output, down marginally from 3.0 percent last year. Italy's benchmark bond yields jumped on the debt market on Thursday as coalition infighting flared again before an auction on Friday of up to 6 billion euros of medium- and long-term bonds. Letta confirmed last week the deficit was off target, as economists and international bodies had suspected for months, blaming political tensions for pushing up borrowing costs for what he said was only a marginal overshoot to 3.1 percent. However, many analysts believe the hole in the budget is larger and caused instead by tax cuts insisted on by Berlusconi's center-right and a deeper than expected recession. "Even to reach 3.5 percent the government will have to take emergency tightening measures," said Citigroup analyst Giada Giani. Last month, Letta finally bowed to Berlusconi's demand to scrap the housing tax IMU with a cost to the state of around 4 billion euros, less than half of which has so far been funded. The government has pledged to find 2.4 billion euros needed to scrap an installment due in December in the next few weeks. A similar story regards sales tax. A one percentage point hike in the main rate of 21 percent was slated by Letta's predecessor Mario Monti to take effect in July, but Letta delayed it to October. Politicians on both side of the political divide, including Saccomanni's deputy Stefano Fassina from the center-left Democratic party, would prefer the sales tax to be scrapped altogether, fearing its impact on the recession-bound economy. (Reporting by Gavin Jones and Giuseppe Fonte; Writing by Gavin Jones; Editing by Ruth Pitchford)