* Portugal to more than halve deficit by end-2015, then more
Needs economic recovery and more permanent spending cuts
* Election in 2015, court challenges may slow budget repairs
By Andrei Khalip
LISBON, March 9 (Reuters) - Portugal's international bailout is expected to end in mid-May. That won't mean the end of hardship for the Portuguese.
To avoid a repeat of the 78 billion euro ($108 billion) financial rescue agreed in May 2011 with the European Union and the International Monetary Fund, Lisbon cannot let up on shrinking its budget gap and trimming a huge sovereign debt.
The economy is starting to grow again , and the government is borrowing at the cheapest rates since 2010. That means it will be easier than in the past couple of years to meet goals imposed on Portugal by existing bailout terms and European treaties between now and 2017.
Still, with a population intent on making ends meet - and a general election due in the middle of next year - assurances from Prime Minister Pedro Passos Coelho often fall on deaf ears.
"I know and (the politicians) know that austerity will continue, because that's what our lenders demand and we still have to pay them back," said Helena Barroso, 51, a literature teacher in a state-funded university in Lisbon.
On Thursday night, more than 12,000 off-duty police gathered in front of parliament, waving banners with the words "Patience has limits!" to demand the reversal of wage cuts that have lopped almost a quarter off average police wages.
"I don't believe things will improve," said Armando Ferreira, head of the police union. "If nothing is done, if we do not show our discontent, things will only get worse."
By several measures, Portugal's centre-right government is sticking to its fiscal commitments better than neighbour Spain.
Portugal beat last year's budget gap target of 5.5 percent of gross domestic product, bringing the deficit below 5 percent, according to the latest review by its lenders. It is expected to achieve a 4 percent deficit target this year.
By contrast, the European Commission expects Spain, which did not undergo a full bailout programme, to miss its 6.5 percent goal in 2013, recording a 7.2 percent gap.
Portugal has to meet a bailout target of 2.5 percent in 2015, then slash the deficit to 0.5 percent by 2017 to meet the European Union's "golden rule" calling for balanced budgets.
Lisbon has to meet these targets regardless of whether it requests a precautionary loan while it eases its way back into full dependence on market financing. The government has said it would decide next month on whether to seek the loan.
But what to cut next is a daunting choice, particularly given next year's election.
Over the past three years under the bailout programme, Prime Minister Coelho has relied largely on tax hikes to narrow the budget gap. Now, the administration has said it will cut the main corporate tax rate this year to 23 percent from 25 percent. It has also not ruled out easing value-added tax for some services from the current 23 percent. The government also hopes to trim income taxes from their record levels in 2015.
"They do want to start easing the high tax burden, but I don't think there's much room to cut taxes without increasing the deficit," said Giada Giani, a Citi economist in London.
The only answer is more permanent spending cuts. Repeated cuts so far have targeted public sector wages, pensions and thousands of jobs. But many such measures are temporary and fall well short of a long-term debt reduction plan.
Moreover, the European Commission said last month that Portugal is still only half-way to getting wages down to levels that could bring down unemployment in a sustainable fashion after wages fell around 5 percent since 2010.
While exports are propping up economic growth, falling wages may threaten a recovery in consumer spending that started at the end of 2013, unless many new jobs materialise fast.
"My quality of life has already dropped a lot," said teacher Barroso, who has lost one-fifth of her monthly pay, now below 2,000 euros, in public sector wage cuts over the past few years, and more in tax hikes.
"They told me it was a temporary cut. Now it looks like it's going to be permanent. Makes you pessimistic."
POLITICAL OPPOSITION, COURT
Permanent cuts are a political gamble. Even if politicians have the courage to impose them so close to an election, such measures would almost certainly be challenged by Coelho's rivals in parliament and sent to Portugal's Constitutional Court.
The Court has already rejected some measures and is currently looking into whether some one billion euros in this year's wage cuts are constitutional.
"Budget discipline will remain there, but I think they will slow down on deficit cuts, doing only something that's more politically acceptable on the spending side," Citi's Giani said, adding the deficit target of 2.5 percent next year may not be achieved. A gap of around 3 percent is reachable and enough to keep investors calm, she said.
A year before elections, opinion polls show the centre-left Socialists a few points ahead of the ruling coalition, though not with enough votes to win an outright parliament majority.
But "even with the Socialists at the helm, the policy of budget balance that depends on Europe should continue," said Antonio Costa Pinto, a political scientist in Lisbon.