Stephen Foley: Bush tax cuts impasse threatens recovery

US Outlook: American politics has gone through the looking glass. The Republicans, who have fought every economic stimulus to date, are pushing for the extension of Bush-era tax cuts for the wealthy, saying an economic downturn is no time to raise taxes. The Democrats, who previously downplayed towering deficits, have got fiscal religion and argue the cuts must be reversed. Inevitably, the explanation is naked interest-group politics.

George W Bush's giveaways – introduced in two tranches, in 2001 and 2003 – comprised dividend and capital gains tax cuts, an estate tax cut and a reduction in the top rate of income tax, as well as a few cents off income tax for the middle class.

The measures disproportionately favoured the wealthy, and that is the lobby which has swung into action in the past month, sensing weakness in the Obama administration. The President promised during his election campaign to extend only those cuts that applied to Americans earning less than $250,000 a year, but his opponents are now arguing that renewed taxation of the well-to-do would hurt the very job-creating entrepreneurs and small business owners the economic recovery needs.

The whole package of Bush cuts is due to expire at the end of December, setting the scene for a showdown before the mid-term election over what should be extended and what should not.

The cuts that Mr Obama wants to make permanent amount to about $255bn a year; the cuts the Republicans are gearing up to defend cost another $55bn. The difference is not immaterial to the budget deficit, and the horrors of compound interest should not be underestimated. This week, the non-partisan Congressional Budget Office calculated that extending all the tax cuts would lead to a modest improvement in employment and economic growth next year, but with serious consequences for the national debt over the long run, sending it to 100 per cent of GDP by the end of the decade, compared to 60 per cent if all the cuts expire under current laws.

There ought to be ample room for compromise. Lawmakers could reach up into the $55bn tranche to extend tax cuts that might genuinely boost the recovery. Capital gains tax rates could be kept low to spur long-term investment, to take one obvious example.

But in the heated atmosphere, and in a Senate where a single Senator can hold any legislation to ransom, there is a real risk that a deal will fail and all of the cuts will be left to expire. That would be too traumatic a fiscal tightening.

Not for the first time, the recovery of the world's most important economy could be derailed by shenanigans in Congress. The financial markets will be watching closely as lawmakers return from their summer break.