The decision taken on Tuesday by the commission, the EU's executive arm, starts a three-week countdown for the populist government to present a new, pared-down spending plan.
The European Union has never punished a member country over a budget, but Rome's intransigence could trigger a clash with the commission that could lead to hefty fines.
Here are some key ideas for understanding the EU's labyrinthine budget process:
What is Brussels' problem with Italy's budget?
At the heart of the concerns is Italy's public debt, which amounts to a jaw-dropping €2.3 trillion. This represents some 131 percent of Gross Domestic Product (GDP), the biggest rate in the eurozone after Greece.
That ratio is more than double the 60 percent of GDP limit set by European rules and above the eurozone average, which stands at around 86.5 percent of GDP. Brussels has demanded Italy cut spending and reduce its public deficit in order to pare down the debt pile.
But on October 3rd the Italian government irked Brussels and provoked the markets by tabling a draft budget that boosted overall spending instead of cutting it and forecasted a public deficit of 2.4 percent of GDP in 2019.
Italy's deficit itself is not problematic: it has been below the EU's three percent of GDP ceiling since 2015 and in 2018, it should be 1.7 percent.
The key piece of data for Brussels is the so-called structural effort, a technical term for long-term reforms such as pension cuts and labour laws on hiring and firing. Further angering Brussels, Rome has decided to reverse course on these tough reforms, vowing to increase spending instead.
READ ALSO: Here are the main things included in Italy's 'people's budget'
Photo: Filippo Monteforte/AFP
What can the EU do about it?
In 2013 during the heat of the crisis, the commission, the EU's executive arm, was handed new powers to enforce budgetary discipline in the eurozone through fines and a right of veto.
In rejecting the budget on Tuesday, Commission Vice President Valdis Dombrovskis said Brussels had no choice but to ask for a revised budget.
"The Italian government is openly and consciously going against commitments made," Dombrovskis said. Rome, he said, had failed to clear up concerns the EU has raised for months.
The revised plan must be submitted by November 13th. The Commission would then study it and give a new verdict toward the end of November.
If Rome remains defiant, then Brussels, backed by the ministers, can open an "excessive deficit procedure" which could theoretically lead to financial sanctions. Based on EU law, these can go up to 0.2 percent of a nation's annual economic output, about €3.4 billion for Italy.
The 19 eurozone finance ministers then meet on December 3rd and will give their verdict, based on the commission recommendation.
Though the fight could drag well into next year, analysts at Barclays believe Brussels favours a quick decision, at least before the election campaign for a new European Parliament in May.
Since the process was created in 2013, bad students have so far escaped financial sanctions.
Would Brussels really punish Italy?
For Economic Affairs Commissioner Pierre Moscovici, "the rules are not stupid" and should "be flexible and adapt to situations."
France is the most controversial escapee, after slipping by for nine years with a public deficit above the 3 percent of GDP limit. Brussels repeatedly issued angry warnings, but Paris was never punished, drawing bitter criticism from balanced budget sticklers, such as Germany and the Netherlands.
Similarly, Spain and Portugal avoided fines in 2016 despite public deficits well beyond the limits.
But in the end, even if Brussels shirks from playing the enforcer, the markets could.
Traders, as well as the Italian government, are braced for the opinions of credit ratings agencies within the coming weeks. Downgrades could accelerate a flight of investors away from Italian debt, thus sending the government's borrowing rates soaring and threatening the country with a default.
Moody's ratings agency, meanwhile, this week revised its ratings of 12 Italian financial institutions, having downgraded Italy's standing by one notch on Friday over concerns about its budget. But this time around it was a mixed bag, with some being revised downwards and others up.
READ ALSO: EU slams Italy's 'unprecedented' breaking of budget rules
Photo: Alberto Pizzoli/AFP
By AFP's Alex Pigman