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BRUSSELS, May 14 (Reuters) - Italy's deteriorating public finances will break European Union rules this year and next unless Rome alters its policies, but the EU executive is split on how to best handle the case of the euro zone's third-biggest economy, EU officials said.
The European Commission is closely watching Italy because of the country's huge public debt, the second highest in Europe after Greece, which the Commission forecasts will rise this year and next instead of falling as EU rules dictate. Italy's budget deficit is to rise too, against the rules, while growth stalls.
Yet outspoken Italian Deputy Prime Minister Matteo Salvini, whose right-wing League party is in government with the populist 5-Star movement, said the country was ready to break EU fiscal rules -- remarks that sent the euro lower.
Italian and other politicians across the 28-nation bloc have sharpened their rhetoric ahead of elections to the European Parliament being held in all EU countries on May 23-26.
"The Commission is split on Italy -- there are those like Vice President Valdis Dombrovskis who want harsher action and those, like Economic Commissioner Pierre Moscovici, who push for dialog and compromise," one EU official said.
The tougher course would be EU disciplinary steps that could end in fines, something Italy avoided last December through a deal in which the EU forgave Rome its consolidation obligations and which the Commission called "not ideal" and "borderline."
But since December, Italy's economic data and outlook have only become grimmer, increasing investor worries about Rome's ability to service its obligations.
"We're very cautious on Italy right now," said Mohammed Kazmi, a portfolio manager for UBP in Geneva.
"What we're seeing in the past few days from the Italian cabinet is that instead of calming the fears of the European Commission following its deficit forecasts, Salvini talked about how he's willing to go ahead with a VAT cut."
SHOWDOWN ON JUNE 5
The Commission will issue a report on Italian public finances on June 5 that could conclude with a call for disciplinary steps to start. The final decision will fall to Commission chief Jean-Claude Juncker, who has in the past tended to side with Moscovici, officials said.
France, Portugal and Spain all avoided being fined for breaking EU rules thanks to that approach. Some officials said Juncker, who will leave the Commission in October, would stick to his lenient stance and leave the issue to the next EU executive.
"It will be legacy time: will Juncker want to end his term with the opening of the first debt-based EDP (Excessive Deficit Procedure) for Italy, a procedure that it will be very difficult to get out of once launched, and which he fought hard to avoid as recently as December? Probably not, but who knows," a second official with insight into the Commission's thinking said.
Being tough on Italy would be hard for Juncker, the official said. "That would go against the instincts he has demonstrated in recent years which are more like Moscovici's -- dialog over confrontation on these matters," the second official said.
Pressure from markets could play a role -- Salvini's remarks drove Italy's 10-year bond yield to two-month highs of 2.755%, up 6 basis points on the day, while shorter-dated two-year and five-year yields rose 8 bps each on Tuesday.
The closely-watched spread between 10-year Italian and German bond yields hit its widest level in three months, at 282.6 basis points.
Latest Commission forecasts show that Italian debt will rise this year to 133.7% of GDP from 132.2% in 2018. Next year it will go up even further, to 135.2% of GDP.
This is in violation of EU rules, under which Italy's debt should be falling every year by 1/20 of the difference between the present level and the 60% ceiling permitted by EU treaties, calculated as an average over three years.
Of even more concern to investors, the Commission expects that Italy's primary balance, the amount of money the government has before debt servicing costs, is to drop to 1.2% of GDP this year from 1.6% in 2018 and tumble to only 0.2% in 2020, a worrying sign for a country with a large public debt.
All this as Italy's economic growth is forecast to almost grind to a halt this year, after being revised down from the 1% expansion that the December compromise was based on. (Additional reporting by Dhara Ranasinghe; Reporting by Jan Strupczewski; Editing by Catherine Evans)