By Lesley Wroughton

WASHINGTON, Nov 1 (Reuters) - Palestinian finances have been slashed by 60 percent due to Western aid cuts to the Hamas-led government, with most public servants living on a fraction of their wages, the International Monetary Fund said on Wednesday.

An IMF fiscal and financial report on the West Bank and Gaza pointed to a faltering Palestinian economy and a government struggling to make ends meet as donors maintain an aid freeze to force Hamas to recognise Israel, renounce violence and accept past peace deals.

Hamas won an election in January and the government was sworn in at the end of March.

The IMF said Palestinian budget resources had shrunk to around $500 million between April and September this year, compared to over $1.2 billion in the same period last year. Preparing the 2006 budget had become "a meaningless and an impossible exercise", it said.

"The government's revenue base has been declining with the faltering economy, due to the fiscal crisis combined with intensified restrictions on the movement and access of foods and people by Israel," the IMF said.

Scarce resources have been used mainly to pay government employees and to finance fuel imports, leaving little for ministries' running costs and social transfers, the IMF said.

It said state workers on average received wages equivalent to only 40 percent of their normal income.

The problem has been made worse by a sharp rise in the government's payroll by 5,400 to 142,000 at the end of June, mostly due to an increase in security forces.

In addition, close to 20,000 new security recruits were in training and may eventually be added to the payroll, the fund said.

The IMF said since early June the government had paid its lowest-paid employees, mostly in cash through the post office because of international restrictions on bank transfers.

Some workers had also been paid through a so-called Temporary International Mechanism, set up by international donors to channel assistance directly to the Palestinian people, by-passing Hamas.

Looking ahead, the IMF said that even if the political situation in Palestine improved substantially, politically difficult measures would be needed to put government finances on a sustainable path.

It said the Palestinian Authority would need to find ways to reduce the wage bill and ensure utility fees were paid, while taking steps to streamline social transfers and reform a generous -- and unaffordable -- pension system.

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