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* Senate leaders optimistic on compromise
* Senate Democrats willing to drop demand for surtax
By Richard Cowan
WASHINGTON, Dec 15 (Reuters) - The U.S. Congress, facing end-of-year deadline pressures and an unhappy electorate, rushed on Thursday to find compromises on legislation to keep the federal government functioning through 2012 and extend a payroll tax cut for 160 million Americans.
After weeks of stuck negotiations and political bickering, Senate leaders said on Thursday they were optimistic a bipartisan compromise was nearly at hand on the two bills that could demonstrate to voters that Washington is able to function cooperatively - at least for now.
Senate Majority Leader Harry Reid, a Democrat, opened Thursday's session of the Senate saying that "in the next few days" the legislation could be wrapped up, allowing lawmakers to go home for the holidays after a year of bruising fights over budget and tax policy.
Senate Republican leader Mitch McConnell was similarly upbeat, saying he was "confident and optimistic we'll be able to resolve both (bills) on a bipartisan basis."
The upbeat assessments - the first in weeks - came a day after Reid, McConnell and House of Representatives Speaker John Boehner, a Republican, huddled in the Capitol to talk about a way forward.
It also was on the heels of Senate Democrats making it known they would be willing to drop their demand for a surtax on income over $1 million to cover the cost of keeping the payroll tax lower for another year. Late on Wednesday, McConnell downplayed the importance of the Democratic overture.
House Republicans announced they would hold a vote on Friday on their version of a nearly $1 trillion spending bill to keep federal agencies, ranging from the Defense Department and Homeland Security to labor, environment and education agencies, operating through the fiscal year that expires on Sept. 30, 2012.
It was unclear whether the separate Senate negotiations would overtake the bill Republicans were pushing through the House.
Also expected to be included in the year-end bills is an extension of long-term unemployment benefits that are set to start expiring early next year. It was unclear whether Republicans would succeed in paring back those benefits.
President Barack Obama's temporary payroll tax cut, first enacted a year ago, would be extended for another year at a cost of about $120 billion. Lawmakers are negotiating over how to cover those lost revenues and not add to budget deficits that have been more than $1 trillion annually for the past three years.
Republicans and Democrats have been looking at using war savings stemming from upcoming combat troop withdrawals from Iraq and Afghanistan. They also have weighed cutting federal worker pension benefits, auctioning more broadcast airwave rights held by the government and raising fees investors pay for mortgage transactions involving government-sponsored agencies Fannie Mae and Freddie Mac.
Under a potential deal, the payroll tax that workers pay would stay for another year at 4.2 percent, down from the normal 6.2 percent. Democrats argue the tax cut puts about $1,000 more in workers' hands that they can spend and hopefully stimulate the economy.
Republicans have questioned the effectiveness of the tax cut but have lately supported its extension, while also proposing some controversial add-ons that Democrats object to.
One of those initiatives, paving the way for quick approval of the Canada-U.S. Keystone XL oil pipeline over Obama's objections, could be negotiated away in a compromise deal, but that was still unclear.
It also was unclear whether Boehner could marshal enough Republican votes in the House to pass a payroll tax cut measure without the Keystone pipeline provision.