By Donna Smith and Rachelle Younglai
WASHINGTON (Reuters) - Deeply divided U.S. lawmakers eked out an agreement on Friday to extend payroll tax cuts for just two months and only after Democrats bowed to Republican demands on a controversial oil pipeline.
The deal, which still needs the approval of the full Senate and House of Representatives, fell far short of President Barack Obama's push for a one-year extension of the tax relief and long-term unemployed benefits to boost the country's fragile economic recovery.
The Senate will vote on Saturday on the agreement as well as a separate 11th-hour $1 trillion (643.2 billion pounds) deal that averted a government shutdown and funds federal agencies through September 2012. Both are expected to pass.
The surprisingly modest payroll tax accord will likely do nothing to dispel concerns among American voters and investors of deep dysfunction in the U.S. capital. It also creates more uncertainty about Washington's ability to steer the nation through global economic turbulence.
Partisan rancour has derailed efforts to forge a deficit-reduction plan, brought the government to the brink of a shutdown three times this year and led to a downgrade by Standard & Poor's of the United States' coveted AAA credit rating in August.
It was not clear how Friday's deal would affect Obama, but he has faced persistent criticism from his base of liberal-leaning voters for caving in to Republican demands on policy issues ranging from tax hikes and spending cuts to environmental protections.
"At one minute to midnight and the end of the year the Democrats appear to have conceded two significant issues on the payroll tax cut and they got a measly two-months extension in return," David Gergen, an adviser to two former Democratic and two Republican presidents, told Reuters.
Senator Carl Levin told reporters of a "sober" reaction when his fellow Democrats were briefed on the agreement.
But Democrats put a brave face on the deal, saying it would give them another opportunity early next year to fight for another payroll tax cut and tax hikes on the wealthy to pay for it -- two arguments that play well with Democratic voters.
To try to break a stalemate in the payroll tax cut negotiations this week, Democrats first dropped their proposal to pay for it with a surtax on millionaires. Then on Friday they abandoned what had appeared to be a non-negotiable demand -- for the Keystone XL oil pipeline from Canada to Texas to be kept separate from the payroll tax cut issue.
The deal requires Obama to make a decision on allowing construction of Keystone within 60 days or declare that "oil trade with Canada is not in the national interest of the United States," according to an aide to Republican Senator Richard Lugar.
BATTLE RESUMES IN NEW YEAR
Obama recently put off a decision on the pipeline until 2013 while the government studies alternative routes. Many interpreted that move as a way to appease his environmental base in his bid to win re-election in November 2012.
Friday's deal immediately drew fire from environmentalists, who said it was an example of Republicans holding the federal government hostage on behalf of the oil industry.
"We're disappointed that the president seemingly signed off on this deal, but we expect that he's going to live up to his promise ... that he will turn down the permit for the pipeline," said Daniel Kessler, spokesman for Tar Sands Action, a group that opposes the project.
Kessler said he expected members from his group would reprise their protests about the project at Obama's campaign offices across the country.
An Obama administration official said in agreeing to the deal, the president had been driven by concern about the economic damage if tens of millions of families faced higher taxes with the coming of the new year.
Obama stood by the State Department's warning on Monday that a Republican effort to limit the pipeline review to 60 days would violate environmental laws and force it to withhold approval, the senior official said.
However, that could make Obama vulnerable to charges that he is stopping construction of a project that his opponents say will create tens of thousands of jobs.
On Capitol Hill, Republicans were quick to tout the deal as a major coup.
"I think the Keystone pipeline component is certainly a very large victory," said Republican Senator Bob Corker.
Senate Republican Leader Mitch McConnell told reporters: "We extended the payroll tax holiday as far as we could get credible payfors to pay for it." He added, "We'll be back discussing the same issues in a couple of months."
That would mean another contentious battle in the midst of the 2012 primary season, which kicks off on January 3 in Iowa.
"If Republicans want to be back here in two months trying to explain why they don't want to give middle-class families a tax cut yet again, that's their choice, we're happy to have that conversation," a Democratic aide said. "We feel that's a home turf game for us."
Democrats had been pushing for some tax hikes on the wealthy to help pay for the payroll tax cut -- such as ending a corporate jet tax break -- but they are not included in the deal, according to one congressional aide.
The $30 billion to $40 billion in lost revenues from extending the payroll tax cut for another two months would be covered by raising fees investors pay for mortgage transactions involving government-sponsored agencies Fannie Mae and Freddie Mac, according to sources familiar with the deal.
(Additional reporting by Thomas Ferraro, Richard Cowan, Kim Dixon, Jeff Mason, Matt Spetalnick and Tim Reid, editing by Mary Milliken and Ross Colvin)
