* National gov't proposes lowering municipal victory margin
* Electoral law change would boost embattled conservatives
* PP betting on economic recovery for national election win
* But 92 pct do not believe crisis is over, poll finds
By Elisabeth O'Leary
MADRID, Sept 4 (Reuters) - Confronted by a steep fall in support after years of economic crisis and scandals in the ruling class, Spain's conservative government has proposed an electoral reform it says will improve democracy but critics fear could help keep discredited elites in power.
The move appears to have been prompted by the whirlwind success of 8-month-old leftist party Podemos ("We Can"), which has taken mainstream politics by storm to become Spain's third-biggest party, a hair's breadth behind the Socialists .
The credibility crisis of Spain's two main parties - the People's Party (PP) conservatives and Socialists - (PSOE) is evident in their decline from a combined 80 percent of votes cast 10 years ago to around half of intended votes now.
If consolidated, their broad losses to smaller parties could mean that by the time the next national election is due, in late 2015, they themselves could be forced into what up to now had been unthinkable - a grand coalition.
With that threat looming, the PP government says it plans to change the format for the May 2015 municipal elections to give anyone with 40 percent voter backing the automatic right to form a government, less than the full majority needed at present.
The government has touted the idea as a response to the Spanish public's demands for more real democracy - one major factor behind the rise of Podemos.
But critics have derided the measure, saying it could well assure PP victories in many town halls unless rivals form coalitions. That is a tall order at a time when politics is more deeply polarised than usual.
Although the economy is expanding again after five years of on-off recession, one in four is unemployed and the privileges of the political establishment grate on the average voter, while scores of corruption inquiries against mainstream politicians and associated businesses are backlogged in courts.
Polls consistently show unemployment, fraud and the political class at the top of the list of concerns.
Podemos is headed by telegenic university professor Pablo Iglesias, who has plugged into discontent with the well-connected - "the caste", as he calls them - and speaks in unusually simple terms to engage the public in political debate.
Faced with that, the big establishment parties look stale.
"(Prime Minister Mariano) Rajoy faces a dilemma: if he does not reform the electoral law, the PP could lose a number of key cities in municipal elections," said Antonio Barroso, political analyst at Teneo Intelligence, a consulting firm.
"(But) were they to impose the reform of the electoral law, opposition parties would probably use it as one of the main campaign slogans against the PP in next year's election."
The potential change can be passed easily given the PP's absolute majority in the national parliament. Some think the PP will eventually back off, such as Carlos Barrera, who teaches politics and communication at Navarre University.
"I think it is a PP strategy to try to head up a debate. That way they can say that they have tried (to respond to a need for change), but the other political parties have refused."
However, respected conservative columnist Jose Antonio Zarzalejos, writing in elconfidencial.com, described such a potential shift in the law nine months before the municipal vote as "despotic", and attributed it to the clear possibility of the PP losing major town halls in Madrid, Valencia and Seville.
WHO SAID RECOVERY?
The PP is hoping that gathering economic growth, in contrast to a still-dismal outlook in core Europe - Germany and France -- will see its star rise again and that unpopular austerity to whittle down a towering public deficit will be forgotten.
But the Sigma Dos poll last weekend showed that 92 percent of Spaniards do not believe the crisis is over.
Voter support for the PP has fallen by around a third since the 2011 general election. But it is still the leading party because the Socialists' (PSOE) collapse has been worse still.
Amid the rise of Podemos, the Socialists are still reeling and have hemorrhaged support beyond a election loss in 2011.
Pablo Iglesias, a regular on a popular Saturday night TV debate, portrays the two biggest parties as beneficiaries of an outdated, corrupt and opaque political system set up after veteran dictator Francisco Franco's death in 1975.
"If the people don't take up politics, others will take it up for them, and when that happens your rights, your democracy and your wallet will be robbed," he has said in interviews.
As proponents of greater wealth distribution, public control over the economy and giving more say to voters on important reform issues, Podemos have won most votes on the left of the spectrum, making the PSOE look conservative and slow to react.
A new Socialist leader, 42-year-old economist Pedro Sanchez, took over in July after Podemos became a pivotal player in European elections in May, compounding the Socialists' woes. He has brought with him other new faces at the top of the party, but has so far not stemmed the decline in voters.
This week, Sanchez announced that primaries to choose a general election candidate would be delayed until July from this autumn, lining up the possibility of more changes.
"The Socialists are still perceived as not having known how to manage a severe economic crisis when they were last in government (in 2011)," said Navarre University's Barrera. (Editing by Mark Heinrich)