UPDATE 3-Portugal faces court battle after budget passes

* Thousands 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 to keep its international bailout afloat.

Thousands of protesters rallied in front of parliament after the vote, booing the lawmakers as they left the building in their cars and shouting anti-government slogans.

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.

The two parties of the centre-right ruling coalition, which have 132 seats in the 230-seat parliament, voted for the bill at its first reading. All other parties voted against, including the main opposition Socialists, whose previous administration requested the bailout in April 2011. There were no abstentions.

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 rallies 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 violent unrest seen elsewhere.

Several thousand protesters, including striking stevedores and unemployed youths from the ``Indignados'' group, rallied outside parliament, chanting: ``The time has come for the government to go!'' or ``This budget will not pass!''

``I am against all the measures by this government, they have been humiliating us for more than a year now,'' said Fernanda Rodrigues, a clerk in Lisbon who took part in the rally.

In a pun on the premier's last name, Coelho, which means ``rabbit'', several protesters carried toy shotguns and cages, with placards saying: ``The rabbit hunting season is open.''

Opposition politicians and some protesters were furious at what they saw as government lawmakers having cut short the budget debate due to concerns about protests outside parliament.

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

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 before signing off on it.

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 partly 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 over 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.