* Letta faces rush to cut deficit, prepare 2014 budget
* Berlusconi allies defiant after parliamentary defeat
* Solid Berlusconi breakaway group would boost Letta
* Senate vote on Berlusconi's future on Friday
By Gavin Jones
ROME, Oct 3 (Reuters) - Fresh from surviving a politicalcrisis, Prime Minister Enrico Letta must return rapidly toItaly's daunting economic problems but much depends on the fateof the man who tried to bring him down, Silvio Berlusconi.
If a split in Berlusconi's People of Freedom (PDL) partybecomes permanent after this week's failed attempt to toppleLetta, the centre-right could become less bellicose in demandingthe tax cuts that split the coalition and strained publicfinances.
An early signal may come on Friday when a cross-party Senatepanel is expected to recommend the media tycoon should lose hisseat in parliament following an August conviction for tax fraud.
Letta's supporters hope this will lead to the centre-rightcamp playing a more cooperative role in what has been an unrulyleft-right coalition. "It will be a test for the right to provewhether they have truly modified their line towards thegovernment and towards Italy or whether once again the realissue for them is the legal situation of Berlusconi," saidcentre-left parliamentary deputy Dario Nardella.
Problems put on ice by the government crisis are morepressing than ever. Economy Minister Fabrizio Saccomanni willpresent delayed emergency measures next week to try to rein inan overshooting budget deficit.
Then by Oct. 15 the government must unveil its 2014 budgetaimed at stimulating a stagnant economy while still holding thebudget deficit below the European Union's ceiling of 3 percentof output.
With the euro zone's most sluggish economy for more than adecade and youth unemployment of 40 percent, Italy is indesperate need of political cohesion to pass overdue reforms toits labour market, education and justice systems.
Berlusconi was forced into a humiliating U-turn on Wednesdaywhen PDL rebels decided to back Letta in a Senate confidencevote, defying the man who has dominated the centre-right for twodecades.
Yet it is still unclear if the rebels led by Berlusconi'sformer lieutenant Angelino Alfano will launch a separate party,how solid it would be or how much public support it would get.
Some of those questions might have been answered at a newsconference planned by Alfano and the other PDL ministers onThursday which was cancelled at the last moment after a migrant boat sank off Sicily, killing more than 100 people.
Berlusconi and his followers were licking their wounds onThursday but the 77-year-old leader remains formally in chargeof the party and his rallying calls for tax cuts and against theleft still hold appeal for millions of Italians.
"Losing a battle does not mean losing the war," one of hisclosest allies Daniela Santanche said. "This is not the end ofthe Berlusconi era and it's not the start of a new era."
On Thursday, Italian government bonds had recovered most butnot all of their losses caused by Berlusconi's attempts to sinkLetta, but analysts warned instability was still a concern.
"We continue to think that snap elections are likely to beheld in the first or second quarter of next year," BarclaysCapital wrote in a note to clients.
Ratings agency Moody's also warned on Thursday that thepersisting political instability was a threat to its Baa2 ratingon Italy and said it expected Rome to fail to bring the budgetdeficit below the 3 percent ceiling this year.
The emergency deficit cutting package was the spark whichset off the political crisis when the cabinet failed to agree onthe measures at a meeting last Friday which was also intended tocancel a planned increase in sales tax.
The sales tax increase went ahead on Oct. 1, to the fury ofBerlusconi, retailers and consumer groups.
If the increase remains in place it will benefit statefinances by 1 billion euros ($1.4 billion) this year and 4billion in 2014 but may further depress already falling consumerspending as the economy struggles to emerge from its longestpost-war recession.
Addressing the Senate, Letta made no reference to cuttingthe sales tax or to a previous promise, made at the demand ofthe centre-right, to eliminate the second instalment of thehousing tax IMU, due in December.
Saccomanni and Letta would prefer not to scrap the IMUpayment, which would make it much easier to meet this year'sdeficit target. If they can quietly forget the promise on IMUwith the consent of Alfano's PDL rebels, that would be a sign ofmuch easier times ahead for Letta and the government.
- Politics & Government
- Budget, Tax & Economy
- Enrico Letta