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By Paul Taylor

BRUSSELS (Reuters) - European Union officials are engaged in a last-minute drive to try to persuade France and Italy to change their 2015 draft budgets before they submit them to the European Commission next week to avoid likely rejection, EU sources said on Friday.

European Council President Herman Van Rompuy made the plea to French President Francois Hollande and Italian Prime Minister Matteo Renzi in private talks on the sidelines of an EU employment summit in Milan on Wednesday, one source said.

He also urged German Chancellor Angela Merkel to make a move on boosting public investment in the flagging euro zone economy if the French and Italians commit to deeper structural economic reforms, the source said.

Merkel said for the first time on Thursday that her government, which has been single-mindedly focused on balancing its own 2015 budget, was looking at ways to promote investment, notably in digital infrastructure and energy networks.

Paris and Rome have defied Brussels by announcing budgets that fail to meet commitments to reduce their public deficits in structural terms - allowing for the business cycle - and saying the EU should focus on promoting investment and growth instead of pushing them into recession.

France is farthest from the goal. It plans to shave its budget shortfall only slightly to 4.3 percent of national output next year from 4.4 percent in 2014 and take another two years until 2017 to reach the EU treaty limit of 3 percent of GDP.

Italy is aiming for a deficit of 2.9 percent of GDP next year but it has a higher public debt level and will not make the structural adjustment mandated by EU rules.

Other member states, especially those who have been through wrenching austerity programmes, are insisting the budget rules should not be bent for the euro zone s second and third biggest economies.

The French know that if the Commission sends back the budget it is a big slap in the face for Hollande, which would be politically difficult, a source familiar with the discussions said. It s the same for Italy.

So far France and Italy are refusing to budge, but intensive talks will continue over the weekend on the sidelines of International Monetary Fund meetings in Washington, and at a euro zone finance ministers meeting in Luxembourg on Monday.

Senior EU officials in Washington for the IMF meetings, questioned about France s budget, said Paris had not yet submitted its numbers and underlined that it was still possible for the draft announced on Oct. 1 to change.

No comment was immediately available from Hollande s office. In Italy, Renzi s chief of staff Graziano Delrio said earlier on Friday that the government was not worried that its 2015 budget plan would be rejected.

HOLLANDE UNAWARE?

Finance Minister Michel Sapin said flatly this week that Paris would not cut more than the planned 21 billion euros from public spending in 2015 nor raise taxes and questioned the Commission s power to reject a national budget.

The EU source said Hollande did not appear to have been fully aware of the EU executive s enhanced powers to send back budgets to capitals for redrafting, under legislation adopted during the euro zone crisis.

Economic and Monetary Affairs Commissioner Jyrki Katainen has been leading talks with the French and Italians but Commission President-elect Jean-Claude Juncker and Van Rompuy have now got involved to try to avert a political crisis that could blight the start of Juncker s term from Nov. 1.

One option was for France and Italy to submit their existing budgets on Oct. 15 but reach some understanding in advance about changes that would be made once the Commission rejected them, the source said.

However Van Rompuy was convinced there is no such thing as a constructive rejection , since it would spark a political furore in the countries concerned, so he was racing to seek an agreement before the deadline for submission.

Under the proposed deal, details of which were sketchy, Paris and Rome would also commit to go further than previously announced in implementing labour market reforms to ease hiring and firing, the source said. Such reforms are acutely sensitive and could trigger strikes and protests.

Germany would agree to a further increase in the capital of the European Investment Bank, last raised in 2012, and the EIB would be instructed to take on higher-risk projects, the source said.

In a separate development, Jeroen Dijsselbloem, the chairman of the euro zone finance ministers, proposed on Friday a new growth deal for Europe which would reward governments reforming their economies with cheap European funds for investment and leeway on budget consolidation targets. [ID:nL2N0S5192]

(Editing by Mark John)


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