U.S. Democrats question Obama's tax deal

WASHINGTON (Reuters) - U.S. President Barack Obama's plans to extend tax cuts for all Americans ran into trouble on Tuesday when his fellow Democrats questioned whether he had been too quick to compromise with Republicans.

While analysts believe Congress will probably approve the deal, Obama faced a rift with many in his party who worried about its impact on the federal budget.

Stock markets in the United States and Europe initially applauded the proposed deal on taxes and unemployment benefits as it may give economic growth a boost in 2011, but U.S. Treasury bond yields rose sharply late in the day.

Democrats had sought tax reductions only for the lower and middle class and their support for the deal remained unclear before they hand over control of the House of Representatives to Republicans in January.

Obama said the deal would give a much-needed boost to the economy, which is still struggling to recover from the deepest recession in 70 years.

"This package will help strengthen the recovery. That I'm confident about," he told a news conference.

Economists reckon the compromise tax plan should eliminate uncertainty on tax policy, help reduce unemployment and raise economic growth in 2011.

The deal calls for a 13-month extension of unemployment benefits, which could placate Democrats, but Obama also conceded to Republican demands on the estate tax by proposing a 35 percent tax with a $5 million individual exemption level.

The Obama plan would cost $501 billion in lost tax revenues, according to the non-partisan Congressional Budget Office, at a time when voters are increasingly concerned about budget deficits that have approached 10 percent of economic output in recent years. A Senate Republican aide estimated the tax cuts will cost $700 billion.

LONG RUN PAIN?

Moody's Investors Service said U.S. finances could suffer in the long run, though it did not foresee a change to the country's AAA credit rating in the next 18 months to two years -- an assessment shared by other analysts.

"This reduces revenue on top of extending jobless benefits, which is bad for deficits. In the short run this is good news, but two to three years down the road foreign buyers of U.S. Treasuries may start to balk," said David Carter, chief investment officer at Lenox Advisors in New York.

U.S. and European stocks initially rose on prospects that the tax breaks will prompt increased consumer spending and buoy the economy. Investor relief over the tax deal waned late on Tuesday though, with the U.S. Treasury's benchmark 10-year bond suffering its worst day since June, as its yield rose to 3.14 percent on concern about the budget deficit longer term.

Taxes would go up for almost all Americans if no extension is approved, and analysts predicted the measure would ultimately become law as enough Republicans would back the deal to offset the Democrats who oppose it.

House Speaker Nancy Pelosi said Democrats would "continue discussions" on the deal in coming days. Representative Steny Hoyer, the No. 2 House Democrat, said he had not yet decided whether to back it.

In the Senate, Democratic Leader Harry Reid called the deal "only a framework," but a key independent senator predicted more than half of the Democrats in that chamber would ultimately back it.

The White House pointed out that the deal would achieve Democrats' priority by preventing a tax increase for working families that would average $3,000. It would also help those struggling in the wake of the worst recession since the 1930s by extending unemployment benefits and other tax cuts focussed on those with more modest incomes, the White House said.

Economists estimated the plan could raise economic growth by 0.5 percent to 1.0 percent next year and significantly lower unemployment.

"In all likelihood, the recovery would have made it through next year without backtracking into recession, but this deal improves those odds significantly," said Mark Zandi, chief economist at Moody's Analytics.

The deal would create 2.2 million jobs, according to the liberal Centre For American Progress think tank, giving a much-needed boost at a time when Congress has been unable to pass spending-based fiscal stimulus measures.

Federal Reserve Chairman Ben Bernanke last month called for additional fiscal measures to supplement the central bank's $600 billion effort to spur demand by buying government bonds.

But many Democrats argued that Obama had given Republicans their top priority -- extending the tax breaks for the richest 2.0 percent of U.S. households -- without getting enough in return.

Some said Obama should have fought harder to set the tone for future negotiations with Republicans.

"By giving in this early I think we've just emboldened them," said Representative Raul Grijalva, a leader of the Progressive Caucus who said he would vote against the deal.

A Republican aide warned that his party would block the inclusion of Build America bonds, a taxable bond program popular with states, cities, and other municipal issuers. Democrats said the issue was still on the table.

Tax breaks for ethanol, clean technology, and employers who hire unemployed workers were also in the mix.

(Writing by Andy Sullivan; Additional reporting by Donna Smith, David Morgan, Jeff Mason, Lucia Mutikani, Thomas Ferraro, Richard Cowan, Walter Brandimarte and Ryan Vlastelica; Editing by Alistair Bell and Clive McKeef)