Italian Prime Minister Enrico Letta speaks during a joint news conference with Finnish counterpart Jyrki Katainen (unseen) at the end of a meeting in Rome October 14, 2013. REUTERS/Tony Gentile

By Roberto Landucci and Giuseppe Fonte

ROME (Reuters) - The Italian cabinet on Tuesday approved a 2014 budget containing tax and spending cuts aimed at stimulating the recession-bound economy while keeping the budget deficit inside the European Union's 3 percent of output ceiling.

"I don't want to make dramatic claims but this is a significant step in the right direction, with lower taxes for companies and workers," Prime Minister Enrico Letta told reporters during a break in the cabinet meeting.

His left-right coalition government approved the main structure of the package just a few hours before the end of the October 15 deadline imposed by EU law, but the cabinet meeting resumed to continue ironing out details.

The budget, which aims to reduce Italy's fiscal gap in 2014 to 2.5 percent of output from a targeted 3.0 percent this year, must now begin its passage through parliament.

The budget contains a cut in the so-called tax wedge - the difference between labour costs and take-home pay - worth 10.6 billion euros (8.94 billion pounds) in 2014-2016, Letta said in a broad presentation of the main numbers in the three-year financial plan.

The tax reduction, aimed at boosting stagnant business investments and consumption, will be split between 5 billion euros for workers and 5.6 billion euros for companies.

For 2014, the cut amounts to a total of 2.5 billion euros, much less than was called for by both employers and trade unions, highlighting the difficulties for the government in identifying offsetting spending cuts.

Yet even before the package was presented, employers' lobby Confindustria, which wanted a cut in the tax wedge of at least 10 billion euros, said the plan appeared too timid "to meet the aim of boosting the slow recovery that is emerging."

The euro zone's third largest economy has been in recession since the middle of 2011 and, after years of recession and stagnation, is smaller now than it was in 2001. The government forecasts growth of 1 percent in 2014, but most analysts expect expansion to be closer to 0.5 percent.

The details of how to distribute the tax cuts to workers would "be up to parliament and the social partners", Letta said.

The tax cuts will be partly funded by 2.5 billion euros of cuts to the central government in 2014-2016 and a cut of 1 billion euros to funding for the regions.

"GREATER OPTIMISM"

"There is reason to look at the future with greater optimism," Economy Minister Fabrizio Saccomanni said, adding that markets would reward Italy's determination to meet its fiscal commitments and tackle structural reforms.

Italy has seen its borrowing costs fall steadily since Letta overcame an attempt by centre-right leader and coalition partner Silvio Berlusconi to bring down the government last month.

On Tuesday the main gauge of investor confidence, the yield gap between Italy's benchmark 10-year bonds and their German equivalent, stood at 2.3 percentage points, down from more than 3 points during the government crisis.

However Italy's finances remain finely balanced. Last week the government approved emergency measures to keep this year's deficit inside the EU's 3 percent ceiling and in the next few weeks it must find another 2.4 billion euros to fund the scrapping of the end-year payment of the housing tax IMU, or a new hole will open up in this year's accounts.

Meanwhile the country's massive public debt, the second largest in the euro zone, is heading for a new record high of 133 percent of output both this year and next.

The budget contains no cuts to health spending, contrary to media reports in recent days, following fierce protests from Health Minister Beatrice Lorenzin, and Letta said there would be no other cuts to the welfare budget in general.

Banks and insurers are called on to fund a significant part of the tax cuts envisaged over the next three years, through a change in the tax regime covering financial losses which will cost them a total of 2.2 billion euros.

A further 500 million euros will come from the sale of government buildings.

The budget deficit is targeted to fall further to 1.6 percent of output in 2015, 0.8 percent in 2016 and 0.1 percent in 2017.

(writing by Gavin Jones; editing by Ralph Boulton)