April 7 (Bloomberg) -- Ireland’s government cut its economic outlook, increased taxes and said it will take control of banks’ toxic real estate loans to protect the country and its financial industry from the worst global recession since World War II.

“Our confidence, our finances, our exports and our banks have been dented,” Finance Minister Brian Lenihan said in the parliament in Dublin today. The cost of protecting Ireland from default rose after the minister said the government will pay for the bank assets with bonds.

Reeling from the collapse of the property market and the battering of its biggest lenders, the government is trying to escape a growing fiscal crisis as the economy heads for a record 8 percent slump this year. To tackle the deficit, the government will increase taxes on incomes, cigarettes, diesel fuel and cut some tax write-offs, Lenihan said.

After expanding an average 7 percent a year between 1994 and 2007, when it became known as the “Celtic Tiger,” Ireland’s economy shrank last year for first time in a quarter century. Now the slump is deepening as construction shrinks at a record pace, consumer spending plunges and companies from Dell Inc. to Intel Corp. cut jobs.

Bank Plan

Lenihan doubled a special levy on incomes to as much as 6 percent, increased capital gains tax and cut a child support payment to parents in today’s budget. He also said he won’t pay a Christmas bonus to welfare recipients this year.

Under the plan to revive bank lending, Ireland will buy as much as 90 billion euros ($120 billion) in development loans from lenders. While the government will pay “significantly less” than 90 billion euros, reflecting the slump in land values, analysts questioned the increase in the national debt.

“It would be better to use the state pension fund money first before increasing borrowing,” said Rossa White, chief economist at Dublin-based securities firm Davy.

Credit-default swaps on Irish government debt rose to 225 basis points today from 206 yesterday, according to CMA Datavision. They reached a record 396 basis points on Feb. 17.

‘Barometer’

Budget deficits across the European Union have ballooned as governments pour billions of euros into stimulus measures to fight the economic slump. At the same time, tax receipts are falling and unemployment payments are rising. Lenihan is aiming to keep Ireland’s deficit at 10.8 percent of gross domestic product this year, compared with an EU limit of 3 percent.

Ireland’s ability to negotiate its way out of its fiscal problems may become a “barometer” for the strength the 16- nation euro region. Prime Minister Brian Cowen said last month that euro membership “greatly strengthens us at a time when immense forces are at play.”

“What is going on in Ireland is a barometer of lots of the problems that are besetting developed market economies,” said Padhraic Garvey, head of investment-grade debt strategy in Amsterdam at ING. “Moreover, Irish bonds have been singled and bullied as a test case for EMU togetherness.”

The difference in yield, or spread, between Irish and German 10-year government bonds was at 205 basis points today compared with 202 yesterday. The spread was 39 basis points a year ago.

The budget today, the second in six months, comes a week after Standard and Poor’s cut Ireland’s debt rating by one step to AA+. Moody’s Investors Service and Fitch Ratings have also placed Ireland’s rating up for review.

“We are not convinced the government has done enough today to appease the ratings agencies or international financial markets,” said Alan McQuaid, chief economist at Bloxham Stockbrokers in Dublin. “That said, unless you believe the government will default on its debt repayments, then Irish bonds look good value in our opinion.”

To contact the reporter on this story: Ian Guider in Dublin at iguider@bloomberg.net; Louisa Nesbitt in Dublin at lnesbitt@bloomberg.net.

Last Updated: April 7, 2009 14:15 EDT