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Italian government near collapse after budget talks fail

* Cabinet fails to agree new budget measures

* Economy Minister Saccomanni furious

* Coalition close to breakdown over Berlusconi legal woes

* Borrowing costs rise at bond auction

By Francesca Piscioneri and Giuseppe Fonte

ROME, Sept 27 (Reuters) - Italian Prime Minister Enrico Letta failed to secure backing for a vital package of fiscal measures on Friday as divisions with centre-right partners in his fragile coalition took the government to the brink of collapse.

Letta flew back from a visit to New York with coalition unity already in tatters after a threat by centre-right lawmakers to walk out over Silvio Berlusconi's battle against a conviction for tax fraud.

After two days of mounting tension and with financial markets on edge, he met ministers late on Friday in a last-ditch bid to avert a rise in sales tax and secure approval for additional budget measures needed to bring Italy's deficit within European Union limits.

However, with the meeting still in progress, officials made clear that no deal could be reached.

"The conditions aren't in place at the moment," said one official, who spoke on condition of anonymity.

Letta is now expected to go before parliament next week to seek support to continue in office.

Failure to agree on some 3 billion euros of budget measures, demanded by both Letta's centre-left Democratic Party (PD) and Berlusconi's People of Freedom (PDL), underlined the breakdown between the two traditional rivals which were forced together by last February's deadlocked election.

Economy Minister Fabrizio Saccomanni, who has staked his credibility on meeting the EU budget limits and faced constant sniping from the PDL over recent months, was furious at the breakdown, officials said.

PDL lawmakers said proposals to avert the one percentage point rise in sales tax, scheduled to take effect in October, would have been funded by an increase in fuel taxes which would have punished consumers.

With the sales tax hike, passed by the previous government led by Mario Monti, due to kick in on Tuesday, prospects for a deal appear remote.

"We can't accept the blame for this," PDL secretary Angelino Alfano, who is also deputy prime minister, told the cabinet, according to one official. "We can't stay in the government if taxes are going up and there are no cuts to spending," he said.


Letta's left-right coalition has flirted with collapse ever since Italy's top court convicted former premier Berlusconi of tax fraud last month and sentenced him to four years in prison, commuted to a year of house arrest or community service.

On Wednesday, PDL lawmakers said they would resign en masse if a Senate committee meeting on Oct. 4 votes to begin proceedings to expel their leader from parliament.

On returning to Italy on Friday after courting foreign investors in New York, Letta met President Giorgio Napolitano who, if the government fell, would have to either call new elections or try to oversee the creation of a new coalition.

A spokesman for the president's office said the head of state, who has repeatedly said he does not want a return to the polls, had given Letta his full support to seek the backing of cabinet and parliament.

If Letta, who has a commanding majority in the lower house, can secure the backing of a few dozen Senators among PDL rebels or opposition parties including the anti-establishment 5-Star Movement, he could form a new coalition.

The political convulsions in the eurozone's third largest economy have increasingly worried investors, although with the European Central Bank guaranteeing stability in the markets, there has been none of the panic seen during previous crises.

At an auction of 10-year bonds on Friday, Italy's borrowing costs rose to their highest level in three months, while the premium investors demand to hold Italian debt rather than AAA-rated German paper widened to 267 basis points from under 250 at the start of the week.