* Puerto Rico's yield spread at 300 basis points
* Public pension system has $37.3 bln of unfunded liabilities
* Tepid economic recovery
Feb 4 (Reuters) - Puerto Rico's new government is rolling out tax increases and hiking water and electricity rates in a campaign to fix its finances and win back favor in America's $3.7 trillion municipal bond market.
A big, usually popular issuer of muni debt because its interest payments to U.S. investors are free from local, state and federal taxes, the Caribbean island is weathering a steep increase in yields driven in part by a Moody's Investors Service downgrade of its debt to near junk bond-status.
Investors, including some Wall Street portfolio managers who view Puerto Rican debt as too risky to own, demand rates that include a 10-year Puerto Rico yield that is 300 basis points more than Municipal Market Data's benchmark.
That compares to a yearly average spread of 242 basis points over a market benchmark scale and is much wider than Illinois', which last week yanked a $500 million muni bond sale amid worries about the country's most underfunded public pensions system.
Puerto Rico's public pensions system, with $37.3 billion of unfunded liabilities, also feeds investor fears about the government's ability to service its debt. So, too, do a chronically high jobless rate that was 14 percent in December, a declining population, and chronic budget deficits.
"Shoring up Puerto Rico's credit is essential as our access to the bond market is limited," Javier Ferrer, new president of the U.S. commonwealth's Government Development Bank said Friday. "We lack investor confidence. We need to take big steps to address the deficit to be able to go to the bond market."
The new administration of Gov. Alejandro Garcia Padilla, who in November ousted a pro-business reformer, last week spelled out a plan to increase a controversial tax on multinational companies operating in Puerto Rico and to raise utility rates.
Top officials said legislation would be filed this week to increase the commonwealth's Law 154 tax, which is levied on sales of multinationals in Puerto Rico to offshore affiliates.
In place since 2011, the tax began at a 4 percent rate but was cut to 2.75 percent this year and had been slated to be phased out through further gradual reductions. The tax raised $1.88 billion for the commonwealth in 2012.
The administration announced legislation to revive the 4 percent rate and extend that rate through 2017. Treasury Secretary Melba Acosta said the change would raise an additional $245 million to fund central government operations, with revenues beyond that going to government pensions and related fiscal reforms.
Private enterprise blasted the development, with the head of the Puerto Rico Manufacturers Association saying the increased corporate tax will discourage new investment and jobs creation.
In addition, Acosta said, legislation would be drawn up to boost a sales and use tax, known as IVU by its Spanish acronym, aimed at increasing collections by $380 million. Current Treasury collections are running about $250 million below estimates.
Water bills will also go up by an average $20 monthly starting in July, Puerto Rico Aqueduct and Sewer Authority (PRASA) President Alberto Lázaro said.
The hike comes after the administration's finance team told the public corporation and bond issuer there would be no more subsidies, which had kept water hikes at bay over the last four years. Prasa has a $250 million deficit, driven by heavy debt burden and federal regulatory requirements.
Meanwhile, the Puerto Rico Electric Power Authority, through an adjustment of its fuel adjustment charge, will hike monthly rates by an average $30 over the next several months.
The moves came as signs Puerto Rico's tepid recovery from a deep, six-year recession may be sputtering.
An Economic Activity Index reported by the GDB, which acts as Puerto Rico's fiscal agent, showed the island's economy as contracting in November and December after expanding slightly for most of 2012.
Rating agencies have signaled that action on the government's crippled pension system was essential to skirting a downgrade of commonwealth credit, as was the introduction of a structurally balanced budget in 2014.
Under the former administration of Gov. Luis Fortuno, the government's budget deficit was cut 90 percent to $333 million from $3.4 billion over four years.
A leading lawmaker said last week that a pension reform plan aimed at fortifying the finances of the government pension systems would be ready in March.