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(Reuters) - Puerto Rico's new governor is trying to heal the Caribbean island's wounded public finances with an austere budget heavy with new taxes that could sap life from a wobbly economic recovery.
When Governor Alejandro Garcia Padilla presents his first budget on Thursday, he will be closely watched by America's $3.7 trillion municipal market, which is ever more worried about the U.S. commonwealth's ability to finance its public debts.
All three leading Wall Street credit-rating agencies have in recent months knocked Puerto Rico's credit rating to near junk-bond status, pointing in part to an economy sapped by a six-year recession that only ended in 2012. Further ratings cuts are possible.
The island's unemployment rate is 14.2 percent. It is a major worry for Puerto Rico's government as it presents a fiscal 2014 budget plan that will rely on borrowed money to close gaps. Officials don't expect a balanced budget for another year, at best. The budget plan is expected to face little opposition from legislators.
"As government tightens its belt, one can see the unemployment rate going higher," said Dan Heckman, senior fixed- income strategist at U.S. Bank Wealth Management, a firm that owns very little of Puerto Rico's $53 billion of muni bonds.
"That's one big challenge," Heckman said. "And they are talking about tax increases that can affect hiring and business. You can have unintended consequences when you raise taxes."
Last year, the commonwealth's economy expanded for the first time since 2005, but Puerto Rico's tepid economic recovery now shows substantial signs of sputtering - a turn that would aggravate worries among bond investors about chronic budget deficits and its $53 billion of debt.
In December, January and February, the economy - dominated by manufacturing, finance and government services - ended 12 months of modest but encouraging growth and posted declines from year-earlier levels, according to the Economic Activity Index of the Government Development Bank, which is fiscal agent and advisor to the U.S. commonwealth.
February's coincident index, which tracks payrolls, cement sales, gasoline consumption and electricity use, was off 1.31 percent from February 2012. The data issued last week included especially big declines in cement and electricity consumption.
"That economy will continue to grow slowly," said Anthony Valeri, fixed-income strategist at LPL Financial in San Diego. "If we don't see material improvement in the economy and other debt metrics, we could see a downgrade."
In contrast, economies in the Caribbean and Latin America were getting a lift from strong expansion in Brazil and Argentina, and were forecast on Tuesday by a United Nations agency to grow 3.5 percent in 2013, up from a 3 percent increase last year.
"The economy is pretty blah, pretty tepid, and if the economy were to get worse ... I think a downgrade could come soon," Janney Capital Markets Managing Director Alan Schankel said of Puerto Rico.
Ratings downgrades typically raise interest rates for borrowers, and lenders now require Puerto Rico to pay by far the highest rates of any big issuer. Its weekly spread over AAA-rated yields reported by Municipal Market Data is 320 basis points, well over twice that of Illinois and near the island's all-time high of 340 basis points hit in 2009.
Puerto Rico's $99 billion economy has long endured population declines, double-digit jobless rates and losses of tax benefits that bolstered manufacturing.
The island's economic performance is central not only to Garcia Padilla's budget, but also to dealing with outsized government debt and government pension systems underfunded by $37 billion.
Garcia Padilla, who criticized the austerity measures of predecessor Luis Fortuno, has won praise from Wall Street for okaying sweeping changes in government pensions and leaving in place a long-term leasing to private companies of San Juan's main airport.
The new budget is expected to have revenues of $9.7 billion, including tax increases of about $1.65 billion, according to finance officials.
Earlier this year, Puerto Rico increased an excise tax on multinational manufacturing that raised $600 million annually. The governor also wants to raise $550 million by eliminating deductions and expanding the reach of a sales and use tax.
Some $150 million will be raised through a proposed 4 percent tax on self-employed professionals earning more than $150,000 annually. Officials also want to increase cigarette excise taxes to raise $50 million and boost lottery earnings by $40 million by joining the multi-state Powerball game and other initiatives.
Spending priorities will be crime fighting and economic development, with more resources put into those areas, officials have said.
Reporting by Michael Connor in Miami; Additional reporting by Reuters in San Juan; Editing by Tiziana Barghini and Jan Paschal