(Rewrites throughout with details on fiscal policy, political context)
By Anthony Boadle
BRASILIA, Dec 2 (Reuters) - President Dilma Rousseff's cash-strapped government won approval from Congress on Wednesday to drop its fiscal savings target and run a hefty deficit this year, a crucial vote that will allow it to pay its bills in December.
A severe recession has reduced tax revenues and plunged Brazil into a fiscal crisis that has shaken investors' confidence in the once-booming economy and fueled political disputes over belt-tightening measures.
Congressional approval to change the target from a 1.1 percent primary surplus originally planned to a deficit of up to 2 percent of gross domestic product will allow Rousseff to avert a government shutdown by unfreezing billions of reais in spending.
On Friday, Rousseff's administration was forced to freeze 10.7 billion reais ($2.78 billion) in spending to comply with Brazil's fiscal responsibility law after Congress delayed passage of the bill. The law obliges the government to cut spending to meet the fiscal savings goal.
The government warned Congress on Monday that it could not pay rent, water and electricity bills of its ministries in Brasilia until the bill was approved.
Lawmakers agreed to ease the consolidated primary fiscal deficit goal to a shortfall of up to 117 billion reais in case the government decides to pay massive debts with state-run banks. The primary fiscal balance, or savings prior to debt servicing, is an important gauge of a country's capacity to repay its debt.
In the last few years, Rousseff has delayed payments to state banks, amassing a huge debt that the opposition says was an impeachable violation of Brazil's fiscal responsibility law.
Rousseff is believed to hold enough support in Congress to avert any attempts to impeach her for now, but her relations with her governing coalition are shaky. Her administration says an overhaul of public finances is a key condition to restore growth amid the worst recession in 25 years.
In the third quarter, the Brazilian economy contracted 4.5 percent on an annual basis, the steepest fall on record, official data showed on Tuesday.
Still, lawmakers are dragging their feet to approve an austerity package of tax hikes and spending cuts to reach a primary surplus goal of 43.8 billion reais or the equivalent to 0.7 percent of GDP next year. Many analysts doubt the government will be able to even eke out a surplus as the recession extends through next year and drags down fiscal revenues.
Brazil had its worst primary budget deficit for the month of October on record, central bank data showed on Monday, evidence of the continued deterioration of the country's finances despite government efforts to rein in spending.
$1 = 3.8545 Brazilian reais Reporting by Anthony Boadle; Editing by Chizu Nomiyama and Grant McCool