* Government announces tax credits to ease labour costs
* Funds 20 bln euros in credits with VAT hike, spending cuts
* Business leaders would prefer direct payroll tax cuts
PARIS, Nov 6 (Reuters) - France is to grant 20 billion euros in annual tax credits to companies as a way of lowering labour costs, in a tougher-than-expected response to calls from business heads to reverse decades of industrial decline.
Responding to a call by industrialist Louis Gallois to slash labour charges companies say keep them at a competitive disadvantage, Prime Minister Jean-Marc Ayrault said tax credits would be funded by higher sales tax rates and spending cuts.
The measures fall short of the 30 billion-euro cut to payroll taxes Gallois recommended in a government-commissioned report, but should convince foreign investors the government is serious about getting its ailing economy back on track.
Business leaders said direct cuts to labour charges would have been preferable, but the package was clearly a step in the right direction. French bond yields are at historic lows but are seen as vulnerable to fears that France's economic outlook is as gloomy as that of troubled southern euro zone states.
``France is not condemned to the spiral of decline. But we need a jolt at a national level to regain control of our destiny,'' Ayrault said as he presented the measures.
``This is about giving our companies room to manoeuvre.''
The government will offer 10 billion euros ($12.78 billion)in credits next year, and increase that amount by 5 billion in 2014 and 2015 to a permanent annual level of 20 billion euros, equivalent to a 6 percent easing in labour costs.
To finance that, the main VAT rate will be raised to 20 percent in 2014 from 19.6 percent today and a reduced rate that applies to restaurant bills and property repairs will rise to 10 percent from 7 percent, raising a total of 6 billion euros.
The government also aims to save 12.5 billion euros from cuts to public spending and health insurance from next year.
``Overall, these measures are good,'' Jean-Francois Roubaud, head of the CGPME federation of small and medium-sized businesses, told i>Tele television.
``At the same time, I had been hoping for at least 30 billion euros, and in actual cuts to contributions, because the results of that would have been immediate. I'm worried this method could prove to be very convoluted.''
Industry leaders have lobbied hard for cuts to the high payroll taxes they say are a factor behind a steady rise in France's trade deficit to a record 70 billion euros last year.
Gallois called in his report for shock therapy to remedy the situation, setting a challenge for President Francois Hollande, who has been criticised in opinion polls for being too timid in tackling the economic crisis.
Hollande is hemmed in by the need to rein in public finances and meet an ambitious target to cut the public deficit to 3 percent of economic output next year from 4.5 percent this year.
BNP Paribas economist Dominique Barbet said the main advantage of the government offering tax credits rather than directly cutting social charges was that it would limit the volatility of fiscal income for the state.
``This is significant. It goes in the right direction,'' he said, but also expressed concerns that business would find the tax credit plan complicated to factor in.
With approval ratings as low as 36 percent, Hollande is under pressure to fix problems that have exporters floundering as Germany, helped by low labour costs and a culture of innovation, racked up a 158 billion-euro trade surplus in 2011.
Highlighting the pressure on him, car makers Renault and PSA Peugeot Citroen were both in talks with unions on Tuesday, the former seeking a deal on pay and conditions to cut costs and the latter readying to close a plant near Paris and axe 8,000 jobs.
The International Monetary Fund weighed in on Monday, warning in a yearly report on France that the government must undertake bold reforms to boost competitiveness like its trading partners Italy and Spain - or risk falling behind them.
``France has lost its competitiveness due to being weighed down by taxes,'' Thierry Breton, chief executive of IT services group Atos and a former finance minister and head of various telecoms and technology firms, told BFM TV.
Elected on a pledge to turn around the stalled economy in two years and stem a relentless rise in unemployment, Hollande wants to aid industry but has been wary of shifting too much of the tax burden onto households.
To soothe a disgruntled public, Hollande scrapped a rise in VAT to 21.2 percent proposed by his predecessor Nicolas Sarkozy as a step towards trimming labour charges. But he is also under scrutiny from investors trying to gauge his credibility. Moody's rating agency is due to update its view on France this month.
Whereas the proposal by Gallois, former head of aerospace giant EADS, on cutting payroll taxes would only have benefitted profitable firms, the offer of tax credits will also apply to companies who make too little to pay tax.
On the other hand, construction companies complained that raising the reduced VAT rate would cause job losses.
The government's package also contains incentives for investment in innovation, small businesses and training to try to restore lagging competitiveness that has seen France's share in global export markets slide in the last two decades.
It also proposes imposing a new green tax from 2016.