UPDATE 2-Portugal faces court battle after budget passes

* Protests outside parliament

* Focus to turn to constitutional court

* President could send budget to court

LISBON, Oct 31 (Reuters) - Portugal's parliament approved the biggest tax increases in the country's modern history on Wednesday, paving the way for a court battle over a budget which the government says is vital for keeping its international bailout afloat.

The government of Prime Minister Pedro Passos Coelho has searched for ways to guarantee revenues in order to meet budget goals set under the 78-billion euro ($101 billion) bailout deal with the European Union and International Monetary Fund.

All lawmakers present from the two parties in the centre-right ruling coalition voted for the budget at its first reading while all other parties, including the opposition Socialists, voted against in parliament.

The budget sets Portugal, which this year is suffering its deepest recession since the 1970s, on course for a third year of economic contraction in 2013 as households face higher taxes and record unemployment of over 15 percent.

The 2013 budget, which raises tax rates on income, property and financial transactions, was the government's third attempt in recent months to ensure its budget goals are met. Some households face tax increases equivalent to two months' salary.

The budget is now expected to face an almost certain challenge in the constitutional court on the grounds that the tax increases weigh too heavily on the poor.

The court threw out one austerity plan in July and a second was abandoned after street protests.

``In the national emergency situation Portugal faces we cannot have a political crisis,'' Foreign Minister Paulo Portas of the junior coalition partner CDS told parliament just before the vote. ``Failure to have a budget would imply a serious lack of compliance with the bailout plan.''

Political tension has been increasing and anti-austerity demonstrations have become more common in recent weeks in Portugal, which despite being one of the countries worst hit by the euro zone crisis had so far escaped unrest of the sort seen elsewhere.

Unions and 'Indignados', a group of young unemployed people, staged protests in front of parliament on Wednesday. A few hundred had gathered by the time the vote took place, shouting anti-government slogans.

Opposition politicians were furious at what they saw as government lawmakers cutting short the debate on the budget due to concerns about protests outside parliament.

``This (to vote quickly) is a degrading decision and brings shame on this house,'' said Socialist deputy Sergio Sousa Pinto.

Political experts say the outcome of a court challenge is uncertain. ``If the court finds something unconstitutional, it could still be something relatively easy to fix, or alternatively it could shoot down the budget and cause a political crisis,'' said Pedro Magalhaes, a political scientist at the Social Sciences Institute of Lisbon University.

``It's hard to predict the outcome: it wouldn't be the constitutional court if it were predictable.''


Passos Coelho said the 2013 budget aimed to help Portugal to ``turn the page on one of the most difficult periods of our history'', but the tax increases will cause even greater problems for ordinary Portuguese.

Portugal's judges' union has promised to challenge the budget on the grounds that it goes against the constitutional principle that all should be taxed equally. The Socialists have also said they would challenge it, and the president could submit it to the court himself in the process of signing off on it.

A group calling itself the ``Congress of Democratic Alternatives'' that includes left-wing politicians, urged rejection of the budget, or ``at least for the president to send it to be checked by the constitutional court''.

Filipe Garcia, head of Informacao de Mercados Financeiros, a consultancy in Porto, said it was becoming ever more difficult to enact austerity plans. ``Many Portuguese are beginning to think this route is not paying off,'' he said

The 2013 budget, relying on large increases in income tax, has strained the coalition government. The small rightist CDS party had made clear it would prefer spending cuts to achieve the targets, but subsequently backed down.

Passos Coelho spelled out plans to reform government spending in 2013-14 on Tuesday in a move aimed at soothing CDS concerns.

With the government's popularity already at record lows, a general strike planned for Nov. 14 and some economists warning Portugal could enter a recession cycle like Greece, additional doubt over austerity measures would hurt confidence further.

The economy is forecast to contract at least 3 percent this year and 1 percent in 2013. Many economists think even this is far too optimistic.

The budget predicts unemployment will rise further to 16.4 percent next year from 15 percent now.

The concerns prompted the IMF to warn last week that the risks to Portugal's bailout have ``increased markedly''. Portuguese bonds have also reacted, beginning to reverse sharp declines in yields since the beginning of year.