UPDATE 1-EU's Rehn warns Italy on instability, housing tax
* Rehn warns Italian political uncertainty hurting growth
* Criticises Italy for scrapping housing tax
* Letta government under threat
* Rehn rebuked by left- and right-wing politicians
ROME, Sept 17 (Reuters) - The European Union's top economic official told Italy's parliament its fragile economy cannot afford political instability and criticised recent decisions on taxation.
"Particularly in Italy, where the economy is weak, political uncertainty is a brake on investments," EU Economic and Monetary Affairs Commissioner Olli Rehn said in testimony to the joint budget committees of the upper and lower houses on Tuesday.
Rehn's visit comes at a time of acute political tension in Italy and concerns that its public finances are going astray.
Centre-right leader Silvio Berlusconi has repeatedly threatened to withdraw from Enrico Letta's coalition government if Letta's Democratic Party votes to expel him from parliament after a tax fraud conviction last month.
A parliamentary vote over Berlusconi is scheduled for late Wednesday.
Rehn said Italy's scrapping of an unpopular housing tax (IMU) at the end of last month raised concerns about the country's management of its public accounts, and that Italy needed a long period of structural reforms to improve its economic growth potential.
"We have recommended switching taxation from production onto property and consumption, so the abolition of the IMU goes in the opposite direction," Rehn said.
Letta abolished IMU on primary residences last month at the insistence of Berlusconi's People of Freedom (PDL) party.
The Commission "has a duty to request corrections" when member states take decisions that are not consistent with their commitments, Rehn said.
He added that a new "Service Tax" with which Italy has promised to replace the IMU from next year "could be consistent with our recommendations, it depends how it is set up."
Italy, which is mired in its longest post-war recession, is struggling to hold its budget deficit below the EU's 3 percent of economic output ceiling, and on Friday it will hike its forecast for public debt to a new record above 130 percent .
Berlusconi has been threatening for weeks to torpedo Letta's uneasy left-right coalition, causing market nervousness and a rise in Italian borrowing costs.
Bond yields fell on Tuesday after political sources said advisers seemed to have finally convinced the media tycoon that the hardline stance could misfire for the PDL and for his business interests.
Italy needs to improve its competitiveness by reducing labour costs, as has been achieved in Spain, Portugal and Ireland, Rehn said.
In the tense political environment, he met some hostility.
"Rehn is worried about the abolition of IMU in Italy? Well we are worried that someone like him has influence in Europe," said Maurizio Gasparri of Berlusconi's PDL.
Deputy Economy Minister Stefano Fassina, from Letta's Democratic party, said on Sunday that Rehn "should think about the mistakes the European Commission has made in all these years instead of continuing to give us lessons."
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