* Budget slashes taxes, cuts spending less than planned
* Deficit to observe 3 pct limit but previous targets raised
* EU may insist Italy tightens fiscal stance
* PM Renzi says critics of Italy break rules themselves (Adds quotes, background, details)
By Antonella Cinelli and Giuseppe Fonte
ROME, Oct 15 (Reuters) - Italy presented a tax-cutting 2016 budget on Thursday that Prime Minister Matteo Renzi said would boost economic recovery but which pushes European Union fiscal rules to the limit.
The package, approved by the cabinet after an unusually brief 90-minute meeting, will now go before parliament where it must be passed by the end of the year.
Renzi said the budget will abolish a tax on primary residences, scrap levies on agricultural and industrial equipment, offer tax breaks to companies that invest in machinery and equipment and reduce the television licence fee.
It aims to keep Italy's budget deficit inside EU limits, but slows the pace of fiscal consolidation previously agreed with the European Commission.
"This year not only are taxes not going up but they are coming down," said 40-year-old Renzi, who has made tax reduction a rallying cry ever since taking office in February last year.
However, his coalition government is likely to face tricky negotiations with the Commission over the package. With the economy now staging a recovery after a three-year recession, the EU's economic orthodoxy dictates that now would be a good time to step up fiscal tightening rather than relaxing it.
The budget might not meet EU rules on either debt reduction or the "structural" budget deficit, adjusted for growth fluctuations. Instead of cutting the structural deficit by 0.5 percentage points as the rules prescribe, Italy is proposing to raise it by 0.4 points.
Like last year, when Rome agreed to additional deficit cuts of about 5 billion euros to overcome Commission objections, a compromise is likely to be reached in the next few weeks before EU's executive arm signs off on the package.
The budget hikes the 2016 deficit goal to 2.2 percent of output from a previously given 1.8 percent and marginally raises the forecast for public debt, the highest in the euro zone after that of Greece, to 131.4 percent of gross domestic product (GDP) from 130.9 percent.
Renzi said that nonetheless, the debt-to-GDP ratio would fall next year for the first time in nine years. He was defiant over possible EU objections, saying countries that criticised Italy did not themselves respect the EU's fiscal rules.
It is not just the headline numbers of the budget that are raising eyebrows in Brussels, but also its composition.
The bulk of next year's tax cuts will come from the abolition of a housing tax, TASI, reviving a flagship policy of former centre-right Prime Minister Silvio Berlusconi at a cost of some 3.5 billion euros ($4 billion) to the state.
The Commission says high-tax countries like Italy should instead increase property levies to make room for reductions in labour taxes, which it says would have a better impact on employment and growth.
"The recovery this year has to be sustained and encouraged and the only way to do it is with a fiscal shock," said Renzi, when challenged by reporters. "I hope that the more that taxes come down the more the economy will go up."
Renzi said the corporate tax IRES would be lowered from 27.5 percent to 24 percent in 2017. The cut will be brought forward to next year if the Commission grants Italy more budget leeway over costs it is incurring to cope with the tens of thousands of migrants that have arrived on its coasts in recent months.
Another possible concern for the Commission is that the tax cuts were originally supposed to be funded by reductions in wasteful public spending rather than recourse to extra borrowing, but the "spending review" has made little progress.
Renzi, who had previously lowered an original goal of 14 billion euros of cuts for next year to 10 billion, said on Thursday they would amount to just 5 billion.
Renzi has shown little enthusiasm for the spending review process, which his predecessors introduced to identify specific areas of waste instead of using inefficient across-the-board cuts to the budgets of ministries and local authorities.
Renzi offered little detail on budget line items, but said a significant part of the funding for the tax cuts would come from a scheme to encourage tax dodgers to declare hidden funds in return for criminal immunity.
The "voluntary disclosure" programme, introduced at the start of this year, will bring in 1.4 billion euros this year and 2 billion in 2016, he said. ($1 = 0.8783 euros)
Writing by Gavin Jones; Editing by Crispian Balmer/Ruth Pitchford