By Alberto Sisto
ROME (Reuters) - Italy's government pledged on Tuesday to hike value added tax and introduce a constitutional balanced budget amendment as hundreds of thousands of people went on strike against an already widely criticized plan.
As market pressure on Italian bonds intensified, Prime Minister Silvio Berlusconi's center-right government yielded to demands to strengthen measures intended to balance the budget by 2013.
The 20 percent VAT bracket will be raised by one percentage point to 21 percent and a special 3 percent levy will be imposed on incomes of over 500,000 euros, a statement from Berlusconi's office said.
It also said ministers would approve the introduction into the constitution of a "golden rule" on balanced budgets and transfer provincial government functions to the regions in a move to simplify local administrations.
Other changes would delay retirement for women employed in the private sector from 2014.
A confidence vote will be called which should see the package passed in Senate on Wednesday, offering some reassurance ahead of Thursday's meeting of the European Central Bank governing council which has been pushing Rome for action.
Approval in the lower house would then be needed for the package to be passed.
"The VAT hike and the willingness to work on pension reform will help reassure markets," said Barclays Capital economist Fabio Fois. "That said, in order to turn market sentiment decisively, they have to work more on growth measures."
With markets alarmed at Italy's lack of progress in reining its 1.9 trillion euro debt, Rome's borrowing costs have risen inexorably for more than a week, despite intervention by the ECB to hold yields down by purchasing Italian bonds on the market.
The premium that investors require to hold Italian paper rather than benchmark German bonds reached 369 basis points by late afternoon on Tuesday, more than 30 points above the equivalent Spanish spread.
"I don't think Italy is in full freefall but for sure it is a very critical situation," Nomura rate strategist Laurent Bilke told Reuters Insider Television.
STRIKE
As the government scrambled with the last minute changes to the package, protestors held rallies in around 100 towns and cities as part of a strike against the cuts called by Italy's largest union, the CGIL.
Protests in Italy have not matched the "indignados" demonstrations in Spain or the mass rallies in Syntagma Square in Athens but Tuesday's strike brought out simmering anger at the burdens imposed on ordinary Italians by more than a decade of economic stagnation.
"It's wrong to target people like me. I am on the poverty line. I only make 1,000 euros a month," said Marco Vacca, a 49 year-old employee of an industrial laundry who joined a rally of thousands outside Rome's central rail terminal.
The CGIL, which has not been joined by more moderate unions, said about 58 percent of workers were on strike in sectors affected by the stoppage, roughly in line with other big protests this year.
Trade union protests were also planned in Spain, where parliament is debating inserting a German-style debt brake into the constitution to give greater force to deficit-cutting measures designed to regain financial market confidence.
Spanish unions called evening protest marches to denounce a fiscal rule they say will result in cuts to social spending and affect the poorest in society.
"ALARMING SIGNAL"
Italy's strengthened measures came after a stark warning from President Giorgio Napolitano who said on Monday that markets had sent an "alarming signal" of the need for urgent action to restore faith in public finances.
He said there was time to insert measures "capable of reinforcing the efficiency and credibility" of the austerity package passed in parliament last month.
Economy Minister Giulio Tremonti had long resisted any change to VAT, fearing it would hit consumer demand in Italy's stagnant economy but he failed to come up with any other source for the billions of euros of extra revenue needed.
Italy has wrestled with sluggish growth and one of the world's highest levels of public debt for years but a modest deficit, high private savings and a conservative banking system had kept it largely on the margins of the crisis until July.
Berlusconi's government, which until recently boasted of keeping Italy out of the crisis, has struggled to build a defense against the market pressure, hampered by deep divisions in its own ranks over tax and pension issues.
Measures ranging from a tax on high earners, retirement delays for some university graduates, cuts to local government funding or the abolition of small town councils have been proposed, then dropped with bewildering speed.
(Writing by James Mackenzie; Additional reporting by Catherine Hornby in Rome and Jonathan Gould and Edward Taylor in Frankfurt; editing by Paul Taylor and Andrew Heavens)