ROME—Italy’s austerity measures are stunting activity in the euro-zone’s third-largest economy, recent budget and economic data show, suggesting the steps are backfiring.

The Italian Treasury said late Monday that its state-sector borrowing requirement—a proxy for the budget deficit—fell 10% in the first quarter of 2012 from the year-earlier period.

The figures suggest recent tax increases are helping Italy cut its fiscal shortfall, but also that they are pushing economic activity to contract even faster.

Italy’s gross domestic product contracted 1% in the first quarter from the last three months of 2011, according to an estimate from the Confindustria business lobby.

Associated Press

Demonstrators hold a banner reading “Let’s get rid of the finance government, of the EU and of the social slaughter” during a rally asking for the resignation of Italian Premier Mario Monti and his government, in front of Milan’s stock exchange headquarters.

“With austerity, one doesn’t grow,” Industry Minister Corrado Passera said Tuesday in Rome.

Growth-damping austerity packages seem to be sweeping across Europe, testing the Continent’s approach to managing the sovereign-debt crisis.

The scenario—unfolding now in Italy, Greece and Spain—would leave troubled euro-zone countries with higher public debt ratios even as they take painful efforts to reduce them. That, in turn, would leave the currency union as a whole vulnerable to further market and political tension.

Italy’s fiscal tightening, which began in 2010, is designed to enact tax increases and public-spending cuts amounting to 7% of GDP by 2013. The bulk of the measures are tax increases—on workers’ income, but also on consumption and on property assets—which many economists say have a more recessionary effect than public-spending cuts.

A 1% decline in GDP in Italy would amount to €16 billion ($21.3 billion) in lost activity, far larger than the improvement in the budget figure.

“What happened in Greece may well happen in Italy as well,” said Salvatore Cantale, a professor of finance at IMD Business School in Lausanne, Switzerland, referring to draconian fiscal adjustments that are squeezing GDP and leading to failures to achieve targeted debt and deficit ratios.

Yields on Italian government bonds rose in the wake of the Treasury’s borrowing-requirement report, while those on German bunds didn’t, signaling investor concern at the beginning of a quarter when Rome is set to issue more sovereign debt than any other euro-zone capital.

In another sign of worry in the markets, current prices on three-year Italian Treasury bonds indicate that local banks that used the European Central Bank’s Longer-Term Refinancing Operations to buy domestic debt are now sitting on a loss. The LTRO is a cheap three-year liquidity offer hailed as a game-changer for the euro-area debt crisis.

Silvio Berlusconi, the former Italian prime minister who stepped down in November, said on Tuesday that a planned two-percentage-point rise in the value-added tax rate this fall would “hammer consumption.” He added that many business leaders were considering shifting production abroad.

“The cure that the European Union has prescribed for our country is the one that has already caused a disaster in Greece and is beginning to do so again in Spain,” Mr. Berlusconi told senior officials in his People of Freedom party at a meeting in Rome. Still, he said he saw no alternatives to supporting the technical government of Prime Minister Mario Monti until general elections in the spring of 2013.

“Excess taxes may endanger the right of many Italian companies to exist,” said Mr. Cantale of IMD. He said Mr. Monti should tell Italians “what he has in his hat if the contraction turns out to be stronger or longer than anticipated.”

Worries about permanent losses to Italy’s economy were underscored this week by Unrae, the foreign-car dealers’ association, which said sales in Italy of all cars had fallen 21% in the first quarter—the biggest season for such purchases—and that March unit sales had hit a 32-year low.

“Consumers have insurmountable obstacles ahead of them, with higher income-tax rates from March, higher property taxes as of June and a value-added tax increase in September,” said Unrae President Jacques Bousquet.

Mr. Monti’s property tax is the result of a major effort by his government to avoid burdening productive activity with labor and business taxes. But local authorities have yet to announce the actual tax rates residents will owe, and the levy will likely be collected in two steps, spreading out the shock.

—Domenico Lofano
contributed to this article.

Write to Christopher Emsden at chris.emsden