UPDATE 3-Spain to pass reforms, budget cuts with eye on aid
* Reforms come as social tension, market pressure rises
* New taxes seen on stock transactions, greenhouse gases
* Rajoy's image hit by cigar pictures
* Wage freeze for public servants to be extended
* Spain to cut infrastructure, culture budget - reports
By Paul Day
MADRID, Sept 27 (Reuters) - Spain was set to announce economic reforms and a tight 2013 budget on Thursday, aiming to avoid the political humiliation of having Brussels impose conditions on any request for an international bailout.
Some ministries could see their budgets slashed by up to 40 percent, Spanish media said, as Prime Minister Mariano Rajoy's battle to reduce one of the euro zone's biggest deficits is made stil harder by falling tax revenues in a recession.
"We know what we have to do, and since we know it, we're doing it," Rajoy said on Wednesday as street protests in Madrid and secession talk by the northeastern Catalania region compounded his goverment's problems.
"We also know this entails a lot of sacrifices distributed... evenly throughout Spanish society," he said while visiting New York to attend the U.N. General Assembly.
Details are to be announced at a news conference starting at around 3 p.m. (1300 GMT) following a cabinet meeting.
Thousands of anti-austerity demonstrators demanding that Rajoy resign gathered for a second night on Wednesday near the parliament building, which was guarded by hundreds of police. Protests on Wednesday were peaceful after a march on Tuesday ended in clashes with police.
"The only way we can achieve anything is to be here every day," said demonstrator Adelaida Olivares, who is unemployed.
Rajoy's image has deteriorated rapidly since his party won an absolute parliamentary majority last November.
Newspaper pictures of the conservative premier smoking a cigar on Sixth Avenue in New York while protesters gathered in Madrid fuelled criticism of his detached attitude toward Spain's mounting problems.
Rising calls for independence from within Catalonia, one of Spain's wealthiest regions, ahead of an early regional election set for Nov. 25 have added to uncertainty over Rajoy's ability to make powerful regional barons accept deep fiscal sacrifices.
REFORMS AND CUTS
Reforms intended to win over sceptical investors and control spending are likely to include a new tax oversight body as recommended by Brussels, curbs on early retirement, new taxes on greenhouse gas emissions and stock transactions, and scrapping some tax exemptions.
Business daily Expansion, citing official sources, said the government would save up to 1.5 billion euros ($1.9 billion) by weeding out corporate tax breaks, including reinvestment incentives and exemptions on foreign earnings and dividends.
According to Juan Jose Rubio Guerrero, president of the Independent Forum of Fiscal Analysts, tax breaks are worth 38 billion euros in Spain.
Wage freezes for public employees will also be extended into 2013, trade union sources said.
Cuts in department budgets would range from 4.2 percent at the justice ministry to 30 percent at agriculture, while Industry Minister Jose Manuel Soria said his own ministry would see its budget cut by 40 percent, Europa Press said.
Other media said the public works ministry would reduce spending on infrastructure by nearly a quarter, while the culture ministry budget would be cut by a third.
Spain is talking to Brussels about the terms of a possible European aid package that would trigger a European Central Bank bond-buying programme and ease Madrid's unsustainable borrowing costs. The reforms to be announced on Thursday are meant to pre-empt the conditions that would be attached to the aid.
Uncertainty over the timing of an aid request and divisions within the European Union over a plan to create a banking union sent the yield on Spain's 10-year bond to its highest since the ECB announced its bond-buying plan on Sept. 6.
However, jitters about Spain did not prevent Italy holding a successful debt auction on Thursday, with five-year borrowing costs falling to their lowest level since May 2011 at 4.09 percent compared to 4.73 percent in late August. Rome's 10-year yield also fell to 5.24 percent from 5.82 percent a month ago.
Spain, the euro zone's fourth largest economy, is at the centre of the crisis. Investors fear that Madrid cannot control its finances and that Rajoy does not have the political will to take all the necessary but unpopular measures.
ECB data released on Thursday showed consumers and companies continued to pull their money out of Spanish banks in August, though at a slower pace than in July, with private sector deposits falling slightly more than 1 percent in the month.
Euro zone economic sentiment fell sharply in September, defying expectations, as the region sinks in to recession. Even in the currency bloc's most successful economy, Germany, unemployment crept up for a six successive month in September.
Figures released on Tuesday suggested Spain will miss its public deficit target of 6.3 percent of gross domestic product this year, and on Wednesday the central bank said the economy continued to contract sharply in the third quarter.
Retail figures on Thursday showed sales fell for the 26th straight month in August, adding to pressure for an economy reeling from paralysed domestic demand and high unemployment. aa Critics say Rajoy's measures lack substance and fail to outline convincingly how they will raise the necessary cash.
"On paper they can make it all add up, but it will be hard to make the budget credible given all the reasonable doubts on the deficit target. It will be really tough to make the markets buy it," said a member of parliament for the ruling party, who asked not to be named.
LITTLE ROOM TO MANOEUVRE
Sweeping tax hikes and spending cuts introduced in July mean the government has little room to manoeuvre.
After street protests against austerity turned violent on Tuesday, Rajoy may choose to tread carefully and avoid further cuts to the welfare system. But with pensions one of the largest spending costs, further belt-tightening may be unavoidable.
European diplomats are exerting pressure on Madrid to freeze pensions, although the Rajoy government has been adamant that it would only touch pensions as a last resort.
The 2012 budget, which was delayed after the previous Socialist government passed the baton in advance of a national election last November, was further held up by Rajoy until after regional elections in Andalusia in March.
"The wait for the Andalusia elections sent a very negative signal on what we could expect from the new government. They say they'll do whatever needs to be done, but that needed to be done, and when it wasn't, it hit credibility," said Luis Carames, economist at the University of Santiago de Compostela.
Elections in Galicia, the region where Rajoy was born, and in the Basque Country on Oct. 21 could partly explain his procrastination over the aid application.
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