* Latvia decides on painful budget cuts, tax rises
* Prime minister hopes lenders to approve more aid
* To reduce wages, could spark political backlash
* Pressure on currency eases, devaluation fears remain
(Adds quotes, details on budget package)
By Patrick Lannin and Jorgen Johansson
RIGA, June 9 (Reuters) - Latvia's government on Tuesday backed a new austerity package of tax rises and spending cuts which it hopes will win it more aid from the IMF and EU after days of financial market speculation it might have to devalue.
Painful cuts in spending worth around 10 percent of GDP over three years are key to the measures to ease the Baltic country's economic woes, which have had an ill effect on worried currency markets in eastern Europe and Sweden.
The government said it backed budget cuts this year of 500 million lats ($992.3 million), part of a three-year 1.5 billion lat reduction effort, including reductions in social spending, further cuts in public sector salaries and a new progressive income tax from next year -- a first for a Baltic state.
Prime Minister Valdis Dombrovskis is to discuss the cuts with EU Commission President Jose Manuel Barroso on Wednesday.
The decisions were agreed with social partners like unions and business, increasing their chances of approval in parliament, though the five-party coalition government does have a majority there.
"If we take these decisions and draw up the mid-term strategy then we have very good chances that we will get this loan," Dombrovskis told a news conference, referring to 1.2 billion euros Latvia wants from a 7.5 billion euro IMF-led rescue agreed last year.
Dombrovskis earlier told Reuters he expected the International Monetary Fund to give a green light to further lending after parliament has backed the budget changes.
A second and final reading is due on June 17.
At a meeting of EU finance ministers in Luxembourg, Swedish Finance Minister Anders Borg said Latvia was showing more commitment to tough fiscal policy, though it had to deliver.
"We also have a saying that it takes two to tango and the band is now playing in Riga and therefore we also need reinforced commitment from the IMF and the international community to participate," he added.
MARKET CALMER, WORRIES REMAIN
Worries Latvia might not be able to win more funding have led to fears an economic drop of around 20 percent this year will make a devaluation inevitable and the central bank has had to support the lat currency in two weeks of intervention worth 370 million euros.
Dropping the euro peg could deal a blow to heavily exposed Swedish banks and Latvians who used foreign-denominated debt to buy fancy cars and apartments in a heady consumer boom.
But with the central bank interventions draining market liquidity, the lat has strengthened again and by late trade the euro was quoted at 0.6990/10 lats, a four-month high. The bank intervenes to keep the rate between 0.6958 and 0.7098.
The firmer lat and apparent progress to more international loans have also steadied investors nerves elsewhere.
Swedbank, the largest with Baltic exposure, was up 1 percent, while SEB was down just 0.3 percent.
Both banks' have been highly volatile in recent days due to their exposure to the Baltic recession.
The Swedish crown, also seen as a proxy trade for the thin Baltic markets, was firmer on the day, with the euro quoted at 10.79 after opening at 10.90.
Other eastern European currencies were also firmer.
Dombrovskis rejected reports pensions would be reduced, though supplements made to pension payments might be cut, while value added tax would rise again in future, he said. Though a full progressive income tax system would not be introduced until next year, some higher tax rates could come this year already.
For Latvians, further pressure on people who had a taste of wealth at the height of the global boom could lead to trouble.
Only five months ago, a 10,000-person protest over wage cuts turned into a riot, and unemployment benefits are due to expire for many in the months ahead.
"Further fiscal austerity for an economy which is already expected to contract by 15 to 20 percent will arguably only make the real economy situation more difficult," said Timothy Ash of the Royal Bank of Scotland, who estimated the proposed cuts represent 3.5 percent of Latvian output. (Additional reporting by Anna Willard and Marcin Grajewski in Luxembourg and Timothy Heritage in Brussels, writing by Laura MacInnis, editing by Andy Bruce)