Berlusconi junior described Balotelli as "negretto di famiglia" – with a literal translation of "the family's little nigger". However, the meaning of the word ‘negretto’ is hotly disputed and the phrase could also be translated as “little black boy of the family”.
The utterance came at a political meeting in Monza near Milan and was filmed by local reporters.
It has already caused outrage in Italy, especially after Milan's midfielder Kevin Prince-Boateng won plaudits from Berlusconi senior for walking off the pitch after being racially abused during a friendly last month.
Paolo Berlusconi was attending a rally for a candidate for his brother's right-wing People of Freedom party when he made the comments.
He said: "Okay, we are all off to see the family's little nigger. He's a crazy head. All the young ladies are invited as well - you can even have a chance to meet the president (Silvio Berlusconi)."
Italy international Balotelli joined AC Milan from Manchester City on transfer deadline day last week and scored twice on his debut against Udinese at the weekend.