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Spain's new government said on Friday that this year's budget deficit would be much larger than expected and announced a slew of surprise tax hikes and wage freezes that could drag the country back to the centre of the euro zone debt crisis.
In its first decrees since sweeping to victory in November, the centre-right government said the public deficit for 2011 would come in at 8 percent of gross domestic product, well above an official target of 6 percent.
It announced initial public spending cuts of 8.9 billion euros ($11.5 billion US) and tax hikes aimed at bringing in an additional 6 billion euros a year to tackle the shortfall.
"This is just the beginning ... We're facing an extraordinary and unexpected situation, forcing us to take extraordinary and unexpected measures," Deputy Prime Minister Soraya Saenz de Santamaria said.
Spain has been under market scrutiny over its ability to control its public finances, and Madrid has seen risk premiums soar to record highs on contagion fears as the euro zone debt crisis spread.
Ten days ago the Treasury said the central government budget deficit was on course to meet a full-year target of 4.8 percent of GDP, which analysts said would push Spain's overall public deficit above its 6 percent target for the year.
But the scale of the overshoot took some economists by surprise and led them to forecast a deeper recession, ending the year on a downbeat note for the euro zone as a whole.
"This is a strong shock. I didn't expect this kind of deficit increase. How can we achieve the objective using personal income taxes and capital taxes? This means making the recession much worse," economist at Barcelona ESADE university Robert Tornabell.
While Italy's debt mountain has been the biggest concern in financial markets in recent months, Spain had been seen as faring somewhat better. Measures taken by the previous Socialist government, while costing it the election, have kept the markets from pushing Spanish yields to unsustainable levels.
But as recession looms across the euro zone, the new government faces a rocky few years. After Friday's initial round of tax hikes and spending cuts, it plans to unveil a final 2012 budget by the end of March.
The Socialists cut the budget shortfall from 11.2 percent of gross domestic product in 2009, and the conservatives must take up the baton and bring the deficit down to 4.4 percent in 2012 and 3 percent in 2013.
If the final 2011 deficit hits the 8 percent mark, as the conservatives say, the government will need to make total savings worth more than 35 billion euros in 2012 to meet the official target.
TAX THE RICH
Spain's economy, the fourth-largest in the euro zone, is likely to have shrunk as much as 0.3 percent in the fourth quarter, Economy Minister Luis de Guindos said this week, and many economists expect output to keep shrinking in early 2012.
The collapse of the property market after the 2007 global credit crunch and shrinking consumer confidence have hit the economic cornerstones of construction and services, leaving Spain struggling to grow since emerging from recession in 2010.
Now, the euro zone debt crisis and fear of economic slump across the bloc has hit Spanish export growth, the only element of the economy to promote growth through 2011.
The tax hikes announced by the conservatives on Friday, which they have always said would be counterproductive to a struggling economy, will be aimed at the country's wealthiest.
The government froze civil servants wages, but also pledged to help the country's poorest by raising pensions and holding electricity tariffs steady for small consumers.
Beyond deficit reduction, the new government said it would concentrate its first few measures on the broken labour market, which has left Spain with an unemployment rate more than double the European Union average, and the banking system.
Spain has rapidly lost competitiveness since the birth of the single currency bloc as wages have followed a higher-than-average inflation rate, a situation the conservatives have pledged to changed through labour reform.
Spanish wages have risen by 20.8 percent in 2003-2008 compared to just 9.7 percent in Germany according to data from the IESE business school.
The government is in talks with unions and employers' representatives to produce a reform plan in the first two weeks of January.
Meanwhile, the banking system has been badly hit by the burst property bubble and new Prime Minister Mariano Rajoy has said the banks must be forced to announce losses on the housing market in a new step in the ongoing restructuring plan.
But some economists say that while Spain must reform and cut costs, its future depends on decisions by euro zone leaders on creating a viable backstop for troubled regional economies.
"There is very little that the Rajoy government can do on its own to bring down Spain's borrowing costs significantly, not least as its fiscal policies are going to depress growth further. The real challenge in Spain is to get the economy moving," said Spiro Sovereign Strategy's Nicholas Spiro.