WASHINGTON (Reuters) -- A wrangle over extending tax cuts for millions of Americans will be the first major test of whether President Barack Obama and resurgent Republicans can work together to fix the U.S. economy.
In the wake of the Nov. 2 election in which Republicans won control in the House, Obama and the Republicans must thrash out a deal or tax rates for everyone will rise in January.
The debate over taxes is likely to dominate the "lame-duck" session in Congress starting Monday, so called because the shift in power brought by last week's elections is not reflected until the new members take up their seats in January.
Obama's Democrats, who will continue to control both the House and Senate during the weeks-long session, might also end the "Don't Ask, Don't Tell," policy on gays in the military and ratify a new arms reductions treaty with Russia.
Some senators are pushing for a vote to castigate China during this time for keeping its yuan currency artificially low, but the bill looks set to languish because trade has lower priority than domestic economic matters.
Debate over taxes is the most pressing issue.
Republicans want a full extension of all tax cuts enacted during the administration of then-President George W. Bush which were timed to expire at the end of 2010. They say that failure to renew them would hurt the already ailing economy.
Obama and most of his Democrats favor extending tax cuts only for the first $200,000 of income of individuals, $250,000 for families.
But they argue that renewing expiring tax cuts for any income above those levels would swell the record U.S. deficit and have little, if any, impact on cutting the high unemployment rate, a key issue in the elections.
"This will be their first major battle, which is why Obama, in the end, wants to cut a deal," said Ethan Siegal, an analyst with The Washington Exchange.
"Obama wants to say to the American people, 'I have moved to the center because I recognize elections have consequences, I recognize the incoming power of House Republicans," Siegal said.
Just days after the election, Obama said a possible two-year extension of all tax cuts could at least be the "basis for conversation" that leads to compromise.
"My number one priority coming into this is making sure that middle-class families don't see their tax rates go up on January 1st," Obama told CBS's "60 Minutes."
The president will meet congressional leaders at the White House Thursday to discuss policy, including tax cuts.
With the Republicans in a stronger position next year when Congress reconvenes with new members, the party might let the cuts run out and then wait until January to renew them across the board.
But a Republican aide said some in his party are wary of that scenario as it risks voter backlash if Republicans fail to quickly reach a deal to prevent the tax cuts from expiring at year's end, raising taxes briefly in 2011.
Voters could conclude, "Republicans just took power and the first thing that happens is that our taxes go up," the aide said.
Republicans took over the House of Representatives and won seats in the Senate at last week's elections, helped by voter concern over unemployment and slow economic growth.
It is uncertain if finding common ground on taxes will have much, if any impact, when lawmakers face even tougher issues down the road, like Republican demands to shrink government, slash spending and repeal Obama's healthcare overhaul.
"Each issue will be different," said Dan Ripp of Bradley Woods & Co, a private firm that tracks Washington for investors.
One of the main challenges next year is whether the parties can agree on how to reduce the budget deficit, which at $1.3 trillion is 8.9 percent of gross domestic product.
Proposals by the chairmen of a bipartisan commission on the deficit were met with skepticism from both sides of the aisle this week.
Analyst Siegal said he sees eventual agreement on taxes but predicted, "Republicans will keep moving back the goal posts" on a number of other fronts.
"Republicans are in power next year to stop the Obama agenda. They aren't here to cut deals," Siegal said.
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