By Gavin Jones
ROME (Reuters) - Italian Prime Minister Enrico Letta's near term survival seems to be assured after beating an attempt by center-right leader Silvio Berlusconi to bring down his coalition government.
The government may now be less prone to infighting and instability, but it still faces an arduous task to put public finances on a sound footing and turn around what has been the euro zone's most sluggish economy for more than a decade.
The first priority will be to pass a credible 2014 budget but beyond that a new electoral law is needed to give a greater chance of a durable government in future, the banking system must be mended so it can help economic recovery by lending more and deeper reforms are sorely needed to raise productivity.
Then there is a national debt that has climbed to a record 133 percent of national output to tackle.
By October 15 Italy aims to present a 2014 budget that cuts labor taxes to stimulate the recession-bound economy but also reduces spending to keep the fiscal gap inside the European Union's 3 percent of output limit.
The taxes and social contributions paid by Italian firms are among the highest in the world, crimping workers' take home pay and companies' ability to invest. The budget will reduce this burden by some 5 billion euros, according to government sources, and will also cut the present levels of housing tax.
However, reversing the recent trend of steadily rising taxes risks digging a hole in public finances unless Letta can also cut non-productive spending, something Italy has not achieved during the tough, tax-driven austerity drive since 2011.
Last week the government appointed Carlo Cottarelli, former head of the International Monetary Fund's fiscal affairs department, to identify spending cuts, but the toughest task then lies with Letta in imposing them politically.
Employers' lobby Confindustria is already dismissing the mooted 5 billion euros of lower payroll taxes as a drop in the ocean, and companies will have to bear some of the burden by giving up other tax breaks they enjoy.
The law is blamed for the inconclusive result of February's election and changing it was meant to be one of Letta's top priorities. Yet political vetoes have blocked any progress just as they did under the previous government of Mario Monti.
As it stands, the law ensures a clear majority in the lower house of parliament thanks to a large "winner's bonus" of seats given to the coalition that wins most votes. However in the Senate, which enjoys equal legislative powers, the bonus seats are not distributed nationally but on a region-by-region basis.
With Italy's political landscape divided into three similar sized blocs, this makes it almost impossible for any of them to win an overall Senate majority.
On paper both Silvio Berlusconi's People of Freedom party (PDL) and Letta's Democratic Party (PD) are committed to reform, but critics say they are actually happy with the status quo because the system gives national party bosses tight control over who is elected for their party.
Another charge is that the government and parliament are in no hurry to change the law precisely because they do not want early elections, which by common consent cannot be held under the present system.
The most immediate challenge is Monte dei Paschi, Italy's third biggest lender, which faces nationalization unless it can find private investors for a 2.5 billion euro cash call.
The government has already poured 4.1 billion euros into the scandal-hit bank, whose top shareholder is a foundation close to Letta's PD party, and is loath to take a big stake in it.
Monte dei Paschi's woes have shone a spotlight on the role of banking foundations. The International Monetary Fund has told Rome to ensure more effective supervision of these not-for-profit entities, which are linked to local politics and are core investors in many Italian banks.
Letta also needs banks to resume lending to businesses to spur a fragile economic recovery. Lending to non-financial companies fell 4.6 percent in August - the 16th consecutive decline - while non-performing loans topped 140 billion euros.
Lenders are also vulnerable to market volatility because they hold some 400 billion euros of domestic government bonds.
Goldman Sachs estimates an aggregate capital shortfall of 16 billion euros for Italy's top six banks - which means they could have to tap the market or the state for additional funds.
Despite waves of austerity since the peak of the euro zone debt crisis in 2011, Italy's massive debt has risen considerably both in absolute terms and as a proportion of national output.
Last month the government forecast it at a record high of 133 percent of output both this year and next, the second largest in the euro zone after Greece.
Analysts say until the debt starts to fall Italy will remain vulnerable to market tensions and this can only be achieved through a combination of stronger growth and asset sales.
After two years of recession Italy is expected to grow an anemic 0.7 percent next year but without deep economic reforms the country will be among the first to suffer in future downturns.
Monti pledged privatizations and sales of real estate, yet in a context of depressed equity and property markets and political instability he managed to sell virtually none of the roughly 16 billion euros per year (1 percent of GDP) targeted.
Letta has set a more modest goal of 0.5 percent of GDP per year, but no details have emerged of what he plans to sell. He has rejected calls to sell-off valuable state companies like utility ENEL, saying strategic assets cannot be disposed of.
Under Monti, Italy made some progress in deregulating labor markets and the service sector, but analysts say much deeper and broader reforms are needed to attract investment and raise growth potential which is now close to zero.
Letta has vowed to lower taxes and expenditure, but cuts and any other painful reform will be fought by vested interests in the state sector, the professions, the unions and the parties.
Unlike other countries hit by the debt crisis, Italy has failed to reduce unit labor costs and its productivity has remained stagnant. Its export performance has barely improved whereas Spain and Portugal have made strides.
There is no shortage of areas crying out for reform, from slashing bureaucracy to improving poor education levels, fixing a slow and inefficient justice system and liberalizing professions and services which Monti's reforms hardly touched.
Analysts say further labor reform is also needed to align wages with productivity and raise one of the lowest labor participation rates in the world.
Italy scored bottom in a survey this week by the Organization of Economic Co-operation and Development measuring basic literacy skills among adults in 24 countries, and was second bottom on basic numeracy skills.
(Additional reporting by Silvia Aloisi. Editing by Mike Peacock)