By Giuseppe Fonte and Gavin Jones

ROME (Reuters) -The Italian government on Wednesday cut its growth forecasts for this year and next and hiked its budget deficit targets, as rising interest rates hurt the economy and costly green building incentives weigh on public finances.

Italy, which has the euro zone’s second largest debt pile as a proportion of output, is under growing scrutiny from investors concerned about its weakening economy and fiscal slippage.

The deteriorating outlook poses a tough challenge for Prime Minister Giorgia Meloni, who must find a way to finance tax cuts promised in the 2024 budget to be presented next month without risking a sell-off of Italian debt.

The yield gap between Italian and German 10-year bonds – a gauge of market sentiment towards highly indebted Italy – rose on Wednesday above 1.95 percentage points (195 basis points), its highest since early May.

In its Economic and Financial Document (DEF), which will form the framework for the budget, the Treasury forecast gross domestic product (GDP) in the euro zone’s third largest economy to rise by 0.8% this year, down from a 1% projection made in April.

Next year’s growth target was cut to 1.2% from 1.5%.

“The outlook has changed mainly due to two factors: restrictive (European Central Bank) monetary policy and the war in Ukraine,” Economy Minister Giancarlo Giorgetti told reporters after cabinet signed off on the new forecasts.

The government hiked its 2023 deficit target to 5.3% of GDP from 4.5%, with the effect of the economic slowdown on state accounts exacerbated by costly incentives for energy-saving home improvements.

These incentives, in the form of tax credits, were introduced before Meloni took office last year and helped boost a strong growth rebound in 2021 and 2022 after the COVID-19 pandemic.

However, they have proved a heavier burden than anticipated for state coffers, costing some 54 billion euros ($56.69 billion), or 2.8% of GDP, last year alone, when the deficit came in far above target at 8% of GDP.

The 2024 deficit goal was raised in the DEF to 4.3% of GDP, up from a previous 3.7%.

The public debt, proportionally the highest in the euro zone after Greece, is targeted to remain stable at around 140% of GDP through 2026.

SPENDING LEEWAY

Under current trends, next year’s fiscal gap is on course for 3.6% of GDP, Giorgetti said, well below the 4.3% target.

The difference between the two figures allows leeway worth over 14 billion euros which Meloni can use to fund tax cuts for low and middle-earners, along with other stimulus measures in the budget.

“All the resources we have available will go towards supporting low-earners, cutting taxes and helping families,” Meloni said on Facebook after the cabinet meeting.

The 5.3% deficit-to-GDP target for 2023 also allows some 2 billion euros of spending room to help the economy, as this year’s fiscal gap is on course for 5.2%.

Italy is one of the euro zone countries most reluctant to heed the European Central Bank’s calls for governments to roll back expansionary policies introduced to help people cope with energy price surge that followed the start of the Ukraine war.

Rome must present its budget plan by Oct. 15 to the European Commission, which is aiming to reintroduce amended public finance rules next year, after the old ones were suspended in 2020 due to the COVID pandemic.

The government said in a statement that it believed its new, higher deficit goals would not breach the EU’s new rulebook.

The DEF targets the deficit to return to below the European Union’s 3% of GDP ceiling only in 2026.

Italy’s public debt is targeted at 140.1% of GDP next year. The surge in inflation over the last two years has helped lower the debt-to-GDP ratio because it inflates nominal GDP.

“The debt has substantially stabilised, because from 140.2% of GDP in 2023 we should arrive at 139.6% in 2026,” Giorgetti said.

($1 = 0.9525 euros)

(Additional reporting by Angelo Amante, Federico Maccioni, Antonella Cinelli and Sara Rossi, Editing by Sharon Singleton)

---