Spain should raise taxes and cut government workers' pay to narrow its budget deficit, the International Monetary Fund said Friday.

The international lending group said Spain's deficit is likely to exceed estimates and the government should therefore consider several measures to boost tax revenue.

The IMF suggests the government increase in its value-added tax, or VAT, which is a type of sales tax. Spain should also eliminate a deduction on mortgage payments for first-time homebuyers, which was recently reintroduced, the report notes.

Spain's Prime Minister Mariano Rajoy has resisted increases in the VAT. The previous government boosted it to 18 per cent in 2010, though it remains one of the lowest in Europe. Spain set a goal of reducing its deficit to 5.3 per cent of gross domestic product, or GDP, in 2012.

The IMF report called that goal "very ambitious" and said it would "likely be missed."

Most of the planned reduction in the budget deficit in the next few years comes from spending cuts, the IMF's report said. But those cuts have yet to be specified, which makes it more likely that the deficit will "significantly overshoot targets" through 2015, the report said.

IMF paints bleak picture of economy

Spain should also consider cutting wages for government workers, the report said. Rajoy has frozen wages but resisted cutting them. The previous administration reduced government workers' pay five per cent in 2010.

To make it more likely the spending cuts and deficit reduction will materialize, the IMF said, future VAT increases and public sector wage cuts could be planned, and then canceled if deficit-reduction targets are met.

The government shouldn't reduce its budget gap too quickly, given its weak economy, the IMF said. It should focus on improvement over the medium term.

Spain has made progress on its budget deficit and recapitalizing banks, but investor confidence remains weak, the IMF said. That's driving up the country's borrowing costs.

The IMF's report paints a bleak picture of Spain's economy. Spain is in an "an unprecedented double-dip recession with unemployment already high," the report said.