Prime Minister Mario Monti announced an income tax cut to help low earners, giving a rare lift to struggling Italian households ahead of parliamentary elections next year.
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The unexpected measure was presented in the early hours of Wednesday, along with a rise in value added tax and a raft of spending cuts designed to keep Italy on course to meet budget goals agreed with the European Union.
Monti said the multi-billion-euro tax break, coming into effect at most four months ahead of elections, showed that painful austerity measures implemented by his unelected administration were beginning to produce results.
"Today we can see that budget discipline pays and makes sense," he told reporters after a marathon cabinet meeting.
Economists gave the tax cut a guarded welcome, but said it would do little to address the underlying problem of persistently low growth that has dogged the debt-riddled Italian economy for more than a decade.
Tito Boeri, professor of economics at Milan's Bocconi University, said it went in the right direction but the stimulus package could have gone much further.
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"It's still a very timid measure because the provision is still very limited as far as reducing fiscal pressure on wage earners is concerned. They could have done much more," he said.
The one-percentage-point cut in the two lowest income tax brackets is expected to cost 5 billion euros ($6.45 billion), according to a Treasury source.
The rate will drop to 22 percent from 23 percent for those earning less than 15,000 euros per year, and to 26 percent from 27 percent for salaries between 15,001 and 28,000 euros.
The cuts come into force at the start of next year, just months ahead of elections due to be held by April. The top three income tax bands will remain unchanged.
The government fell short of expectations that it would eliminate a planned two-percentage-point hike in value added tax, due to come into effect in June next year. But it did limit the increase to one point.
Giacomo Vaciago, an economist at the Milan's Catholic University said the tax cut was a "golden pill aimed at creating a bit of hope," but did nothing to address Italy's underlying growth problem.
"In structural terms, for recovery, there's little or nothing. There's no serious, structural discussion of recovery," he said.
The severe austerity imposed by Monti since he took over in November has exacerbated a year-long recession in the euro zone's third biggest economy and has been a focus of criticism from all political factions.
Monti has ruled out running in next year's election but has said he would be available to serve a second term if Italy's fractious political parties proved unable to form a government.
The government forecasts Italy's economy will contract by 2.4 percent in 2012 and 0.2 percent in 2013, and the public deficit is expected to hit 2.6 percent of gross domestic product before narrowing to 1.8 percent in 2013.
But it said it would stick to its commitment to balance its budget in structural, or growth-adjusted, terms.
Compensating for the income tax cut, the government will cut spending to the health system, local services, universities and public transport and removed a range of personal tax breaks.
It also introduced a new financial transactions tax and unspecified "fiscal interventions" on banks and insurance companies.
The transaction tax will help finance tax breaks on wages linked to productivity gains, a measure intended to help ease Italy's long-standing problem of low productivity.
With the euro zone debt crisis showing few signs of easing, a stagnant economy and a towering public debt expected to reach 126.4 percent of gross domestic product this year has limited the government's room for manoeuvre.
Monti, appointed in the middle of a major financial crisis which toppled Silvio Berlusconi's administration, has increased taxes and cut pensions to put the public accounts on track and head off a Greek-style debt disaster.
There were some signs of a pick-up in Italy's economy in data released on Wednesday, which showed a 1.7 percent month-on-month jump in industrial output in August while analysts had expected a decline. But statistics bureau ISTAT said the data may have been distorted by seasonal factors.
Also decided during the cabinet meeting was a reform to the constitution to centralise spending controls over the country's 20 regional governments, which have been the focus of a recent series of high-profile corruption scandals.