(Corrects in para 21 to say France borrows at historically low rates)
* France postpones deficit reduction by a further two years
* Watchdog says government may still be too optimistic
* Follows news Italy also to ease deficit-reduction effort
* No immediate comment from European Commission
By Leigh Thomas
PARIS, Oct 1 (Reuters) - France laid down the gauntlet to EU partners on Wednesday with a 2015 budget setting out how it would bring its borrowing back to within EU limits two years later than promised, a retreat it blamed on a fragile economy.
The announcement from Paris came hours after news that Italy too planned to ease the pace of painful deficit-reduction steps to try to counter another year of recession.
“We have taken the decision to adapt the pace of deficit reduction to the economic situation of the country,” French Finance Minister Michel Sapin told a news conference.
“Our economic policy is not changing, but the deficit will be reduced more slowly than planned due to economic circumstances - very weak growth and very weak inflation.”
Under the French budget plan, the public deficit is set to fall from 4.4 percent of output this year to 4.3 percent next year, 3.8 percent in 2016 and 2.8 percent in 2017 - below the EU-mandated threshold of 3 percent.
Previously, France had promised EU partners it would bring its deficit below 3 percent by next year, a deadline that had already been extended from 2013. France’s spending watchdog doubted even the new targets could be reached.
“No further effort will be demanded of the French, because the government - while taking the fiscal responsibility needed to put the country on the right track - rejects austerity,” the budget statement said.
President Francois Hollande is resisting pressure from some in his Socialist Party to ease off even more emphatically on cutbacks but also has to contend with an approval rating at a record low 13 percent and news a week ago that conservative rival Nicolas Sarkozy, the man he beat in the 2012 election, is making a return to frontline politics.
Sapin, who this month conceded the 2015 deficit target was untenable, reaffirmed forecasts that the euro zone’s second largest economy would grow at a modest 1.0 percent next year, rising to 1.9 percent in 2017.
Despite the governemnt’s decision to lower its sights, the country’s independent public finances watchdog, the High Council of Public Finances, said the revised projections still looked optimistic as far as 2016 and 2017 were concerned.
The government described its effort to shave 50 billion euros off projected public spending volumes between now and 2017 as “unprecedented” - while acknowledging the total volume of public spending would still rise by 0.2 percent over the period.
That would imply public debt ticking up to a peak of 98.0 percent of output in 2016 before a slight fall in 2017. French public spending and the total tax burden - among the highest in the world - would fall only modestly as a result.
The so-called structural deficit, a figure closely watched by EU budget watchdogs as it strips out the effects of the economic cycle, will fall less than hoped by France’s partners from 2.2 percent of output in 2015 to 1.4 percent in 2017.
Incoming European Commission President Jean-Claude Juncker is now under pressure to react firmly enough to avoid a further loss of confidence in the bloc’s already battered budget rulebook. His options include sanctions including hefty fines.
The European Commission, where Sapin’s predecessor Pierre Moscovici has just been named Commissioner tasked with keeping tabs on respect for EU budget rules, declined immediate comment in the wake of the budget bill presentation in Paris.
Advocates of budgetary rigour led by Germany believe the time has come for France to taste some of the fiscal austerity and painful structural reform already undertaken by its southern neighbours in the wake of the 2009-2012 debt crisis.
But Paris can count on allies in Rome, Athens, Dublin, Madrid and elsewhere to support its argument that further austerity would be counterproductive by snuffing out the fragile start of recovery across the euro zone.
Italian Finance Minister Pier Carlo Padoan said on Tuesday he expected a third straight year of recession this year. While Rome would honour a pledge to cut its deficit to the 3 percent EU target in 2014, the aim of bringing the budget into balance in structural terms - adjusted for the effects of the business cycle - would be delayed by a year until 2017, he said.
Hollande has charged Sapin and Prime Minister Manuel Valls with imposing spending caps on individual ministries and Sapin said he would recoup a further 4 billion euros in French public asset sales to pay off debt.
In a bid to return some cash to the pockets of low-earners, the budget will also cancel the existing lowest income tax band - a move to be funded with tax proceeds elsewhere.
Despite its fiscal woes, France continues to borrow at historically low rates - the yield on its benchmark 10-year bond was unchanged around 1.289 percent in early Wednesday trade.
In an interview with Les Echos newspaper, former conservative Prime Minister Francois Fillon - a possible presidential candidate in 2017 - warned nonetheless that France was “on the verge of serious financial accident”.
For table of main budget elements, click on (Editing by Mark John, Brian Love and Alison Williams)