Q+A - Obama's signal, elections tilt Bush-era tax debate

WASHINGTON Nov 5 (Reuters) - U.S. President Barack Obama's new willingness to work with Republicans on tax policy after his Democrats were routed in congressional elections boosts the chances tax rates will not rise for any American, including the wealthiest, come January. [ID:nN04124680]

The White House said on Thursday the president is open to talks with Republicans about extending all of the lower tax rates enacted under former President George W. Bush, after arguing fervently for months the country could not afford to keep rates low on those with individual income above $200,000.

Republicans, emboldened by winning control of the House of Representatives and gaining seats in the Senate, have taken a harder line on making permanent lower tax rates for all Americans, including the wealthiest. Obama still does not want the rates for wealthiest to be set permanently lower.

Most Bush-era individual income tax rates, including those on investments, are to expire at the end of the year. [ID:N04124680]

Republican and Democrats leaders are still sorting through Tuesday's results and plotting strategy on next steps -- leaving the tax issue up in the air when the Congress returns the week after next for a post-election "lame duck" session. Until the new session in January, Obama's Democrats will still be in charge.

"The results of this week's congressional elections have intensified uncertainty around a potential failure to extend the Bush tax cuts," Deutsche Bank economist Peter Hooper said in a note to investors this week.

Below is a summary of the current state of play.

WHAT IS THE MOST LIKELY OUTCOME?

A one- or two-year extension of all current rates may be the most likely given Republican gains and Obama's signal of compromise.

A spokesman for Senate Democratic Majority Leader Harry Reid said he is "still discussing next steps," following Obama's comments.

"The one thing that we are focused on like a laser is that we are going to cut taxes for the middle class," Reid said earlier in the week. "Now, I would hope that the Republicans will not block that. We are going to work with them."

House Speaker Nancy Pelosi, who had taken a hard line against keeping the lower rates for the wealthy, has been silent on the issue, but her power is diminished given the loss at least 60 Democratic seats in that chamber.

On Friday, she said she would run for Democratic minority leader in the new House that seats in January.

COULD GRIDLOCK PREVENT ACTION ON THE TAX ISSUE?

Gridlock is still a distinct possibility and ranks a close second likely outcome.

The tax debate will take place in the context of a $1.3 trillion budget deficit. Also, Congress early next year will have to vote to increase the current $14.3 trillion debt ceiling to avoid a U.S. default.

Extending all of the tax cuts will cost the federal treasury $2.9 trillion over the next decade. Allowing the top rates on wealthy earners to expire would save about $700 billion of that.

Republicans must now decide what their best option is,-- take what they can get from Democrats now or wait until next year -- and some leaders are taking a hard line about what the election meant for their authority.

"House Republicans ran on a "Pledge to America" - which included stopping all the tax hikes," said a spokesman for John Boehner, the presumptive next Speaker of the House of Representatives, when asked if Republicans would agree to a temporary renewal on tax rates for the richest.

"The American people spoke on Tuesday. We heard them, and we'll fight to stop all the tax hikes," Michael Steel said.

Republicans say small businesses would be hurt if taxes on the wealthiest rise. About 3 percent of small business would be impacted, but they accounts for about half of small business income, according to the congressional Joint Committee on Taxation.

The lower rates for the wealthiest would impact about 3 percent of all Americans.

Expiration of all the rates would depress GDP by a percentage point in 2011, according to Deutsche Bank estimates.

Still, even with inaction this year, an extension is seen a near certainty at some point once new members are seated in January so any delay may just be a month or so. [ID:nN03135493]

WHAT IS THE BIGGEST STUMBLING BLOCK NOW?

The issue of permanent versus temporary is now the biggest negotiating hurdle.

Democrats want to consider taxes on middle income Americans separate from taxes on the wealthiest. That way, the next time tax rates on the wealthy expire, it will be harder for Republicans to defend keeping them low.

Most Democrats argue lower rates for the wealthiest should remain temporary, especially given the bloated budget deficit, which which hit 8.9 percent of GDP in the fiscal year that ended Sept. 30.

"Making those tax cuts for the upper end permanent is something that the president does not think is a good idea," Obama spokesman Robert Gibbs said Thursday.

WHAT ABOUT DIVIDENDS, CAPITAL GAINS AND THE ESTATE TAX?

A compromise on extending all of the Bush-era tax cuts would also include extension of lower rates on dividends and capital gains, now taxed at 15 percent.

Obama proposes to raise those taxes for high-earners to 20 percent in 2011, but if Congress fails to act before Dec. 31, the rates for dividends for high earners jumps to 40 percent, a prospect worrying some companies and investors.

"There is pressure on companies to pay dividends ahead of time," said attorney John Harrington, a former Capitol Hill tax staffer who now advises companies.

Any deal on extension is also likely to include the estate tax, which disappeared this year but will come back at higher levels than last year in 2011. (Additional reporting by Donna Smith; Editing by Jackie Frank)