UPDATE 4-Mexico Senate okays VAT tax hike as downgrade looms

* Senate passes increase in value-added tax

* VAT hike may not be enough to stave off rating downgrade

(Rewrites with Senate approval of VAT, income tax changes)

MEXICO CITY, Oct 30 - Mexico's Senate approved a watered-down version on Friday of President Felipe Calderon's proposal to raise the value-added tax rate in order to reduce Mexico's dependence on its waning oil industry.

The vote marks a partial victory for Calderon, whose original plan would have broadened Mexico's tax base but was rejected in the lower house last week.

It was unclear if the rise in Mexico's value-added tax, or VAT, would be enough to stave off a looming credit rating downgrade.

After clearing the lower house, the measure would go to Calderon's desk unless last minute amendments are added that would require approval by the lower house.

Debate continued in the Senate over possible minor tweaks to the bill, which is part of the revenue portion of the 2010 budget. Calderon lacks a majority in either chamber.

Mexican government revenues have plunged this year because of a severe recession and a slump in oil production, which is down by about a quarter from 2004 levels.

The fall in oil output has removed a long-time crutch for public finances that for decades allowed Mexico to keep its tax take at one of the lowest levels in Latin America. A legacy of corruption has also left Mexicans sceptical about taxes.

Lawmakers worry the tax hike could anger voters suffering from a recession. Mexico's economy could contract the most this year since 1932 because of a drop in U.S.-bound exports.

"People are mad not just about the higher taxes but because they don't see the hikes having a beneficial impact on them," ruling party Sen. Teresa Ortuno said.

DOWNGRADE LOOMS

Mexico only collects about 10 percent of gross domestic product in taxes -- roughly on a par with Haiti -- and debt rating agencies are threatening a downgrade if Mexico's government doesn't boost non-oil revenues.

Calderon's conservatives lack a majority in both houses of Congress, and were unable to convince the main opposition party to back a 2-percent sales tax on all goods without exception.

Instead, the opposition Institutional Revolutionary Party, or PRI, supported a government counterproposal in the lower house to raise the VAT tax to 16 percent from 15 percent.

That compromise would raise less revenue than would Calderon's original proposal, leaving the 2010 budget to rely more on deficit spending and hopes of strong oil revenues.

Investors now await Standard & Poor's and Fitch's decisions on whether the bill, if approved on the Senate floor, will let Mexico keep its BBB+ ratings. A one-notch downgrade would still leave Mexico two levels above junk bond status.

"I think this still makes it even money -- it could go pretty much either way," said Enrique Alvarez, an economist with IDEAglobal in New York.

The bill approved by the Senate would also raise the top income tax rate to 30 percent from 28 percent.

Senators were still due to vote on a part of the revenue package that would would set the 2010 federal budget deficit at the equivalent of 0.75 percent of gross domestic product. The measure was approved by Senate committees late on Thursday, when PRI lawmakers abstained on the entire tax package.

Calderon originally asked for a 0.5 percent deficit.

Senators also still need to vote on a measure to set a budget forecast that estimates Mexican crude exports will sell for an average $59 per barrel in 2010 -- higher than the forecast in Calderon's original plan. That part of the bill also cleared committees late on Thursday.

The deficit, oil price estimate and income tax hike were all approved by the lower house last week.

A proposed new tax for telecoms services was not voted in the committees and was left for debate on the Senate floor.