Analysis: Tax deal offers slim hopes on cutting U.S. deficit

WASHINGTON (Reuters) - The $858 billion tax deal approved by Congress on Thursday is "all candy and no spinach," but at least it shows that President Barack Obama and Republicans can cooperate on fiscal issues.

But their new detente will be tested early next year when the budget deficit looms larger on the political landscape. Analysts are skeptical this week's pact can be leveraged into a broad deficit-cutting program, and fear the deficit issue could be kicked forward to the 2012 election.

The tax deal makes the deficit bigger -- just the opposite of what bond markets want -- and it threatens to move taxes off the bargaining table in next year's struggles over federal spending and raising the government debt ceiling.

At the same time, it was expected to give the economy a boost, and if that gets more Americans working, meaningful deficit reduction could be a little easier.

A presidential commission's aggressive plan to slash the $1.3 trillion deficit earlier this month won more bipartisan support than expected.

"It's very likely that parts of the commission's plan end up in the president's budget. ... Otherwise, he sends some very disturbing signals," said Maya MacGuineas, fiscal policy director at the New America Foundation think tank.

Newly elected Republicans are moving the deficit to center stage, even as Congress wrestles this weekend with a stopgap funding measure to keep the government running.

Still, analysts said they were not holding their breath the momentum toward stemming Washington's flow of red ink would result in a major deficit reduction package in 2011-2012.

The tax package "was, as usual, all candy and no spinach," said Brookings Institution fellow Isabel Sawhill.

"It should have been combined with a phased-in reduction of the deficit over the longer term. ... It doesn't send the right signals to our foreign creditors and it doesn't give one much confidence that elected officials are willing to take the tough and painful steps that are needed," she said.

Still, she added, "The package does suggest that the president is moving toward the center and this could open the door to more bipartisan deals in the new Congress."

TAX DEAL EASY BY COMPARISON

The U.S. House of Representatives voted on Thursday to extend for two years tax cuts enacted under former President George W. Bush for nearly all working Americans, while renewing unemployment insurance and providing additional tax relief.

The Senate had earlier approved the measure, which was expected to boost the economy, but add to the deficit and the nation's ballooning national debt of $13.8 trillion.

To win passage of the tax package, Obama retreated from his earlier position that the Bush-era tax cuts not be extended for the wealthy, while Republicans gave ground on unemployment.

Despite the drama surrounding it, the tax deal will look simple compared with the far-reaching compromises that would have to be made in any serious plan to cut the deficit, likely beginning only after the economy stabilizes, analysts said.

"It's much easier to have a compromise that makes the deficit bigger than it is to have one that makes the deficit smaller," said Michael Linden, associate director for tax and budget policy at the Center for American Progress.

He predicted that Republicans, who take control of the House of Representatives in January, would make "aggressive and vague" spending cut proposals next year that would hammer popular non-defense discretionary spending programs such as veterans' health, highway funds, national parks and scientific research.

"Republicans have made clear they're going to push for significant spending reductions next year," said Heritage Foundation fellow Brian Riedl.

BUDGET, DEBT CEILING LOOM

The president's budget proposal, likely to be released in February, and an upcoming vote on raising the government debt ceiling will be key turning points, Riedl said.

When Republicans bring their demands, Democrats will push back, but may be hard-pressed to respond with proposals for tax reform, even in the medium term, having essentially agreed this week not to raise taxes for two years, analysts said.

The debt ceiling will likely be targeted by Republicans "to try to force the president's hand. ... It may not lead to a government shutdown but it is going to be a fairly big stand-off," said John Irons, research and policy director at the Economic Policy Institute.

The result, he suggested, could be that the tax and deficit question gets kicked down the road since Democrats and Republicans may both see the deficit-tax issue as working to their advantage politically.

"It might be the case that Republicans and the president view this as a fight worth having and might be looking toward a rematch," he said, noting the tax deal they cut this week, barring substantive action in the interim, would land the issue squarely in the center of the 2012 campaign.

(Editing by Peter Cooney)