By Patricia Kowsmann and Gabriele Steinhauser 

The European Union's executive arm urged Portugal to take extra measures to keep down this year's budget deficit but stopped short of demanding the government submit an entirely new spending plan.

Friday's decision by the European Commission follows a warning it issued last week that Portugal's draft budget wasn't in line with the bloc's fiscal rules. Officials said earlier this week that to avoid an outright rejection, the government would have to produce some EUR950 million ($1.06 billion) in extra savings.

During negotiations that lasted until late Thursday, Portuguese officials made some concessions, which the commission believes will lead to some EUR845 million in extra savings, said Pierre Moscovici, the EU's economic and financial affairs commissioner. He said the Portuguese authorities believed the extra measures would lead to some EUR1.12 billion in savings.

"Dialogue achieved more than a rejection," Mr. Moscovici said. "But we have to be very careful, those risks are not gone."

To bring its spending plan fully in line with EU requirements, Portugal will have to find ways to find several billions of extra savings. The measures promised this week will reduce the country's structural deficit, which strips out the impact of the weak economy, by 0.1 to 0.2 percentage point, whereas the commission wants a reduction of 0.6 percentage point, Mr. Moscovici said.

The commission will take another look at the budget in May to make a final assessment, he said, adding, "It's still a long, hard slog."

Portugal's finance ministry called the European Commission's decision a sign of confidence in the country, adding that authorities in Lisbon were able "to safeguard the national right to make political choices." It pledged to stick to its strategy of increasing increase indirect taxes and cutting spending that isn't associated with social welfare while lowering taxes on income and raising salaries in the public sector.

Budget troubles could hurt Portugal's credibility among investors less than two years after it exited a multibillion-euro bailout from the International Monetary Fund and the other eurozone countries.

Canadian debt-rating agency DBRS Ltd. could be forced to downgrade Portugal's credit rating to junk, falling in line with the three other major ratings firms. If that happens, the European Central Bank no longer would be able to buy Portuguese debt under its bond-buying program, likely triggering a sharp rise in the interest rates investors charge to hold the country's debt.

The friction between the commission and the new Socialist-led government highlights the dilemma faced by Portuguese Prime Minister António Costa, who is under pressure from Brussels and other eurozone capitals to implement more austerity measures but also to keep his far-left allies in parliament happy. Mr. Costa's party lost elections in October but was able to forge an alliance with three euroskeptic parties that have questioned Portugal's presence in the currency union.

Earlier Friday, Mr. Costa struck a defiant tone following a meeting in Berlin with German Chancellor Angela Merkel. "I don't want to put Chancellor Merkel under pressure here, because surely she has enough on her plate with her own German budget, but Portugal has a readjustment phase behind it," he said at a joint news conference.

Mr. Costa has vowed to reverse some austerity measures imposed by the previous center-right government but nevertheless stick to EU budget requirements. He has said the Portuguese must have more disposable income to boost economic growth.

Under the budget plan presented last month, the government said it would reverse salary cuts in the public sector throughout this year and phase out a special tax on income. It also planned to cut the value-added tax for restaurants to 13% from 23%. To make up for the fall in revenue, it said it would increase taxes on some products including tobacco and oil.

It estimated a structural budget deficit of 1.1% of gross domestic product, and a growth of 2.1%, which was considered too optimistic by a budget watchdog and credit-rating firms, as well as the commission.

Following the commission's criticism, the government made adjustments. It decided to increase taxes on oil products further, impose a new tax on banks worth EUR50 million, cut the number of public employees and tighten control over sick leave. It also is dropping a EUR135 million plan to lower the contribution paid by workers making less than EUR600 a month.

The government revised its growth estimate to 1.8%. The deficit forecast, meanwhile, was lowered to 2.2% from a previous estimate of 2.6%.

The standoff underlines the limitations of exerting control over spending policies in countries that aren't under a bailout program. Under new powers created during the eurozone debt crisis, the commission has the right to assess government spending plans to check whether they are in line with the bloc's debt and deficit rules.

So far, it has given negative opinions and demanded additional overhauls and cuts from several countries--most recently Italy, Spain, Austria and Lithuania--but stopped short of asking for a full new budget.

Part of the difficulty of making a decision on Portugal's budget was due to the complicated nature of the eurozone's budget rules. Its most well-known stipulations--that government deficits can't be more than 3% of GDP and gross debt must be below 60%--are accompanied by a host of exceptions and alternative measurements that fiscal hawks such as Germany have blamed for creating unnecessary loopholes.

In Portugal's case, the focus has been on its structural deficit--a measurement that strips out the fiscal effects of a depressed economy and is supposed to identify a country's actual budget shortfall. But often, national governments and the commission disagree about how much of a country's deficit is down to the economic cycle and how much is ingrained in long-term spending habits.

Zeke Turner contributed to this article.

Write to Gabriele Steinhauser at gabriele.steinhauser@wsj.com

(END) Dow Jones Newswires

February 05, 2016 13:58 ET (18:58 GMT)