U.S. deficit report highlights Obama's challenge

President Obama speaks during a visit to Lorain County Community College in Elyria, Ohio, January 22, 2010.

WASHINGTON (Reuters) - The U.S. budget outlook is "daunting," with deficits stuck at levels not seen since World War Two, congressional forecasters said on Tuesday in a report that lays out the challenge facing President Barack Obama as he seeks to boost the economy while cutting spending.

Obama, struggling in opinion polls, is expected to propose a three-year freeze on many domestic spending programs -- a measure that would make only a small dent -- and outline other measures to try to tame record budget deficits in his State of the Union speech on Wednesday.

Obama could find skeptics among his fellow Democrats in Congress, who aim to bring down the nation's 10 percent unemployment rate through additional spending before the November congressional elections.

The nonpartisan Congressional Budget Office said the deficit for the current fiscal year would come in at $1.35 trillion, slightly lower than the record $1.4 trillion posted in the previous fiscal year, which ended last September.

At 9.2 percent of gross domestic product, this year's deficit still hovers at levels unseen since World War Two and well above the 3 percent level that economists agree is sustainable.

"The federal fiscal outlook beyond this year is daunting," CBO Director Douglas Elmendorf said on his blog.

That will not be welcome news for Obama's Democrats, who have seen little gratitude from voters after approving a massive economic stimulus effort the CBO estimated will add $400 billion to the deficit this year and cost more than $860 billion by the time it is through -- some $75 billion more than originally estimated.

The controversial Troubled Asset Relief Program that bailed out banks and automakers will end up costing taxpayers $99 billion, much less than originally expected, CBO said.

Obama on Tuesday discussed the economy with executives from JP Morgan Chase & Co, Boston Properties, Exxon Mobil and Anadarko Petroleum.

Other companies were reporting job cuts: Verizon said it would lay off 13,000, or 6 percent of its work force, two days after Wal-Mart Stores Inc's Sam's Club said it would cut 11,000.

BORROWING LIMIT

Democrats in coming weeks will have to raise the government's borrowing limit beyond the current $12.4 trillion, which will give Republicans another chance to paint them as out-of-control spenders.

"It appears that the sky is the limit for this tax-spend-and-borrow Democratic majority," said Senator Judd Gregg, the top Republican on the Budget Committee.

Democrats counter that most of that debt was racked up before Obama took office, as Republican President George W. Bush cut taxes while pursuing wars in Iraq and Afghanistan and setting up an expensive prescription drug benefit.

The report "confirms that the recession inherited from the Bush administration continues to erode the budget's bottom line," House of Representatives Budget Committee Chairman John Spratt, a Democrat, said in a statement.

In a signal of how difficult tackling the deficit will be, the Senate on Tuesday rejected a proposed bipartisan task force that would have examined ways to bring the budget under control. The White House is expected to propose a similar commission, but it faces skepticism from Republicans who say it would give Democrats an excuse to raise taxes.

RECOVERY PATH OR DEBT CRISIS?

White House spokesman Robert Gibbs said the president remained committed to halving the deficit by the end of his current term in office in 2013.

At first blush, the CBO report seems to indicate the country is on that path, projecting that deficits will shrink to $539 billion, or 3.2 percent of GDP, in the 2013 fiscal year.

But that assumes Congress will let several tax cuts expire on schedule at the end of the year, which is not likely. Steny Hoyer, the No. 2 Democrat in the House, said on Tuesday that Democrats would seek to preserve middle-class tax cuts.

If those tax cuts and other likely policy changes are taken into account, cumulative deficits would total $12.4 trillion over the next 10 years -- twice the level projected on Tuesday by the CBO, according to the Committee for a Responsible Federal Budget.

"At that level, the prospects for a debt crisis or else a slow erosion of our standard of living are quite significant," the nonpartisan watchdog group said in an analysis.

The years of overspending will catch up eventually, CBO warned. Interest payments will "skyrocket" -- more than tripling over the coming decade to $723 billion a year, the office said. That would crowd out spending on education, transportation and other areas that would strengthen the economy.

The rising cost of healthcare and retirement programs over the coming decade is also likely to eat up an increasing share of the budget, CBO said.

Democrats had hoped their healthcare reform proposal would curb the costs of government health programs, but that measure is in limbo after Massachusetts voters last week elected a Republican senator, costing Democrats their 60-seat supermajority.

Although the recession ended in 2009, the economy will grow at a sluggish rate and unemployment will not fall from 10 percent to its pre-recession level of 5 percent until 2014, CBO said.

The White House deputy budget director, Rob Nabors, predicted the administration could save $250 billion by 2020 without changing its agenda much. "We are slowing the growth of some of these programs while at the same time eliminating things ... that really aren't priorities," Nabors said.

(Additional reporting by Donna Smith, Alister Bull and Steve Holland; Editing by Peter Cooney)