Analysis: Euro crisis tests limits of French exception PARIS (Reuters) - The French consider themselves an exceptional lot. With much of the world's finest food, wine, landscape, architecture, literature and arts, it's hardly surprising. But the French economic exception faces a reality check almost three years into the euro zone's sovereign debt crisis. France's enduring ability to defy economic gravity - adding new taxes on top of one of the highest fiscal burdens in Europe, preserving short working hours, job protection, early retirement and generous welfare benefits - is about to be tested. President Francois Hollande has promised to bring the deficit down to 3 percent of gross domestic product in next week's 2013 budget from a forecast 4.5 percent this year. Unlike many European peers, he plans to achieve two-thirds of the adjustment by raising extra revenue, despite a virtually flat economy, and less than a third by freezing public spending in nominal terms. Public spending accounts for 56 percent of French GDP, the highest level in Europe except for Denmark. The French are bipartisan big spenders. The debt and deficit rose most under conservative presidents Jacques Chirac and Nicolas Sarkozy. From Germany to China, leaders are fretting over France's inability or unwillingness to embrace reforms widely implemented elsewhere to make its economy more competitive. Where others are slimming down the public sector and selling off state assets, Hollande aims to keep the size of the five-million-strong civil service constant, hiring more teachers and policemen but whittling down the armed forces. "Soak the rich" is the order of the day for the "Mr Normal" Socialist who defeated Sarkozy in May, declaring "my main enemy is the world of finance" and opposing austerity in the name of growth. Hollande may water down his flagship confiscatory 75 percent tax on income over 1 million euros ($1.31 million) a year to spare performing artists, "creators" and sports stars. But he is determined to increase the tax take on top salaries, investment income, big corporations, bonuses and stock options to fulfill his campaign promises of social justice and a fair sharing of sacrifices. Yet higher taxation of businesses runs counter to his goal of reviving growth and may raise relatively little revenue. Hollande risks killing the cow he is trying to milk. With unemployment rising above 10 percent as companies from automaker Peugeot to steelmaker ArcelorMittal cut jobs and reduce production in France, he acknowledged last week the country had a problem of competitiveness. All indicators of competitiveness - from unit labour costs to the quality of education and training - show a growing gap with Germany, France's biggest economic partner, highlighted by Paris' trade deficit, which reached 70 billion euros in 2011. Hollande wants to reduce labour costs by transferring social charges to a broad levy on income, and to make permanent job contracts more flexible. He is seeking the consent of trade unions, most of whom are hostile to loosening labour laws. The president hopes through negotiation to avoid the strikes and mass protests that defeated conservative predecessors' attempts to overhaul employment terms. The outcome is uncertain and the reform may end up too small to stimulate job creation. Scalded by Sarkozy's attempts at shock therapy, the French seem to prefer protecting incumbents in work to getting the unemployed and the young into jobs, or see no connection between the two. Indeed France sometimes seems to exist in a parallel universe when it comes to economics. Faced with competition from China and offshoring to low-cost locations such as eastern Europe and Morocco, the first instinct is to demand trade barriers, outlaw redundancies, punish French firms that produce abroad or demand state subsidies. While social democratic parties elsewhere in Europe have adapted welfare policies in hard times to make benefits more selective, targeting the needy rather than spraying money on the middle classes, the French Socialists are an exception. No question of subjecting generous family allowances to a means test or making the better-off pay more for their healthcare or higher education. Equality and fraternity trump affordability. Ironically, former German Chancellor Gerhard Schroeder, a Social Democrat who introduced painful labour market and welfare reforms in 2004, was guest of honor at the French employers' conference this month. His name is rarely mentioned by his French party comrades. So far, financial markets have been indulgent with France, treating its deep, liquid bond market as an alternative to ultra-safe haven Germany, and much safer than Italy and Spain. This has enabled Paris to borrow at historically low rates even as its public debt has risen to 90 percent of GDP, higher than Spain's. French yields shrugged off both the loss of the state's triple-A credit rating from Standard & Poor's in January and a big U.S. investment manager's warning in August that French debt was "significantly overvalued." John Gilbert, chief investment officer for General Re, a unit of Warren Buffet's Berkshre Hathaway empire, raised the prospect that markets might turn on France. Moody's is the next ratings agency due to pass judgment on France's AAA, right after the September 28 budget presentation. But even if it too downgrades Paris, the French seem to be shielded for now from a market stampede by their rank in the pecking-order of European sovereign debtors, and their proven ability to raise taxes. "Sentiment towards Italy would need to deteriorate dramatically for France's bond market to come under severe pressure," says Nicholas Spiro at fixed income consultancy Spiro Sovereign Strategy. Indeed because expectations about reforms under President Hollande are so low, there is more scope for a slight rally if the government starts to get serious about labour market reform. As long as market pressure remains so weak, the French exception seems set to endure, at the cost of an elegant but inexorable decline.