* 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 leaders to reverse decades of industrial decline.
Responding to a call by industrialist Louis Gallois to slash labour charges that put firms at a competitive disadvantage, Prime Minister Jean-Marc Ayrault said tax rebates would be set in proportion to payrolls and funded by higher sales tax rates and spending cuts.
The measures fall short of the 30 billion-euro ($38.40 billion) cut to payroll taxes Gallois urged in a government-commissioned report, but should convince foreign investors the government is serious about getting its economy back on track.
Business leaders said they would have preferred direct cuts to labour charges but the package went in the right direction.
Economists said Socialist President Francois Hollande was sending the right message to outsiders concerned that France's record-low bond yields might understate its economic fragility next to Germany.
``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.
``France must win back its role as a great industrial power.''
The government will offer 10 billion euros in rebates 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.
``GOOD BUT CONVOLUTED''
``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 Hollande, who has been criticised in opinion polls for being too timid in tackling the economic crisis.
Having scrapped a rise in the main VAT rate to 21.2 percent proposed by his predecessor Nicolas Sarkozy, Hollande now risks a backlash from sectors hit hardest by the new rises.
A building sector federation warned jobs would be lost and the head of a national restaurant syndicate, Didier Chenet, said the VAT rise would be ``catastrophic''.
Deutsche Bank economist Gilles Moec noted that even for companies, the tax relief will coincide with higher taxes in the 2013 budget, making the net benefit closer to 10 billion euros.
Yet he said the package sent a positive message while avoiding angering unions, with whom the government hopes to find ways to improve flexibility in hiring and firing laws next year.
``This is a big mental change for the Socialists,'' Moec said. ``It's a clear demonstration Hollande is not impervious to what the private sector is telling him and that he's aware of market pressure. He wants to avoid giving markets a reason to attack.''
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.
Underscoring that pressure, car maker Renault was locked in talks with unions all Tuesday seeking a pay deal to cut costs as it tries to avoid the fate of PSA Peugeot Citroen, which is closing a French plant and axing 8,000 jobs.
The International Monetary Fund weighed in on Monday, saying France must undertake bold competitiveness reforms like its trading partners Italy and Spain or risk falling behind them.
``France has lost its competitiveness due to being weighed down by taxes,'' said Thierry Breton, chief executive of IT services group Atos and a former finance minister.
Ayrault's package also contains incentives for investment in innovation, small businesses and training to try to correct a long slide in France's share in global export markets.
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.
He 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.
As investors try to gauge his fiscal credibility, Moody's rating agency is due to update its view on France this month.
BNP Paribas economist Dominique Barbet said one advantage of offering tax relief rather than cutting social charges was that it would limit the volatility of fiscal income for the state.
``This goes in the right direction,'' he said, noting he was concerned however about the complexity of the plan.
Union leaders voiced concerns about public spending cuts. ``We're already down to the bone in the civil service,'' Force Ouvriere Secretary General Jean-Claude Mailly told RTL radio.