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* Proposal to expand sales tax curbed
* Policymakers to hike corporate, gross sales tax
* Legislative leaders see passage as early as next week
SAN JUAN, June 12 (Reuters) - Puerto Rico policymakers have agreed to hike taxes by $1.5 billion as part of a budget that is key to the Caribbean island avoiding a Wall Street downgrade of its massive debts to junk-bond status.
With over $70 billion of municipal debts, Puerto Rico pays the highest interest rates of any big borrower in the $3.7 trillion U.S. tax-free debt market and since December has been downgraded by the three major Wall Street ratings agency to near junk-bond status.
A loss of investment-grade ratings for Puerto Rico's muni debt could prompt heavy selling by mutual funds and other institutional investors, analysts have said.
Treasury Secretary Melba Acosta told local media on Wednesday that the fiscal 2014 operating budget would sharply reduce a $1.1 billion revenue proposal by Governor Alejandro Garcia Padilla. Instead, the budget would rely on an island-wide levy on gross sales by businesses and increases in corporate taxes.
Facing a June 30 deadline to enact a spending plan for the 12 months starting July 1, legislative leaders said they expected to pass the governor's revised $9.83 billion budget as early as next week.
Bond investors were mostly indifferent to the sources of revenues for the budget but worried that the island's economy may return to recession after a year of tepid expansion, according to Joseph Rosenblum, director of municipal credit research at Alliance Bernstein.
"For this credit to move forward, it needs economic growth. For investors, they want to see a reasonable balanced budget that has reliable revenue," Rosenblum said. "There were some questions about the projections for the governor's (sales) tax proposal."
The so-called yield spread between 10-year Puerto Rico bonds and triple-A Municipal Market on Wednesday fell slightly to around 295 basis points from 300 basis points last week.
Acosta told reporters that policymakers had agreed to scale back by 73 percent the governor's proposed sales-tax expansion, which was strongly opposed by local businesses. The expanded sales tax will be levied only on a small group of industries and will raise $287 million during fiscal 2014.
To make up for the lost revenue, the government will assess a business tax on gross sales on a sliding scale, depending on sales volume. It is expected to generate $522 million.
Another measure would push corporate tax rates back up to 1994 levels, returning the top rate to 39 percent. Rates were slashed by 30 percent under a tax reform enacted in 2011. The measure is expected to generate $270 million.
House Speaker Jaime Perello said the House could approve the full budget by next Wednesday, and Senate President Eduardo Bhatia said the upper chamber was also ready to act next week.
The U.S. commonwealth, which also has $35 billion in unfunded pension obligations, has not had a fully funded operating budget free of borrowing in more than a decade.