* CBO says benefits will swamp economy in long term (Adds Baucus, other details)
By Richard Cowan and Andy Sullivan
WASHINGTON, June 22 (Reuters) - Democratic leaders called on Wednesday for new spending and tax cuts to boost the sluggish U.S. economy, setting up a fresh hurdle for bipartisan efforts to head off a government debt default this summer.
At the same time, a new report warned that the country could face a European-style debt crisis unless Washington cuts spending or raises taxes.
The report by the nonpartisan Congressional Budget Office adds urgency to the work of negotiators, led by Vice President Joe Biden, who are trying to find trillions of dollars in savings as part of a deal that would allow Congress to sign off on new government borrowing before the U.S. runs out of money to pay its bills.
As the group faces competing demands for stimulus and austerity, some have suggested that it may not be able to get a deal done in time to head off a debt default in early August.
Senate Democrats want the deal to include a payroll tax cut, more money for highway construction and clean-energy subsidies to bring down the 9.1 percent unemployment rate.
"Get the recovery right before you get in this deficit-cutting mode," Assistant Senate Democratic Leader Dick Durbin told reporters. "Get people back to work."
Republicans said that idea is not likely to go far in the Biden-led talks, which have largely focused on spending cuts.
"They're not talking about spending money in there," said Ryan Patmintra, spokesman for Senator Jon Kyl, one of two Republicans participating in the talks. Many Republicans view President Barack Obama's 2009 stimulus package as an $830 billion failure and say spending cuts would help the recovery.
Federal Reserve Chairman Ben Bernanke questioned that approach. "I don't think that sharp, immediate cuts in the deficit would create more jobs," he told reporters. "In the short run ... fiscal tightening is at best neutral and probably somewhat negative for job creation," he added.
PRECARIOUS FINANCES
As the United States struggles to emerge from the deepest recession since the 1930s, rising health costs and an aging population pose a longer term threat.
The CBO report found that public debt will exceed the size of the economy by 2021 unless lawmakers raise taxes or scale back benefits.
President Barack Obama is due to meet with Biden and top Democrats from the House of Representatives on Thursday morning to discuss the talks, the White House said.
The Biden group, which includes six Republican and Democratic lawmakers, is racing to complete a deal by next week but negotiators are at odds over the big-ticket items.
Republicans say they will not consider tax increases, while Democrats have said they won't back cuts to expensive health care benefit programs.
The group aims to reduce budget deficits by $4 trillion over the next 10 years to give lawmakers the political cover to raise the $14.3 trillion debt ceiling by a large enough increment to cover borrowing needs through the 2012 elections.
Treasury Secretary Timothy Geithner has warned that the country could default on its loans if Congress doesn't act by Aug. 2, a scenario that could push the country back into recession and upend financial markets.
Obama and House Speaker John Boehner, the top Republican in Washington, want the Biden group to wrap up its work next week to give them time to hammer out the final details. Any stimulus efforts could enter the discussion at that point, a congressional aide said.
The deal would then have to win approval from the Republican-controlled House and the Democratic-controlled Senate -- a tough task for party leaders. Many Republicans have said they won't back a deal unless it includes immediate spending cuts and advances a balanced-budget amendment to the Constitution, which would be unacceptable to Democrats.
Democratic and Republican leaders in the Senate say Congress may have to pass a short-term fix if the Biden group fails to reach a deal soon.
Durbin said Congress could pass a "serious down payment on the deficit" followed by more work on long-term savings.
Many in Congress do not want to focus on the issue longer than necessary. Senator Max Baucus, a Democrat involved in the talks, said a short-term fix was unlikely. "There will be an agreement," he said.
Investors say a temporary fix would likely cost the United States its coveted AAA credit rating, raising borrowing costs and hurting the fragile economic recovery.
Moody's main analyst for the United States Steven Hess told Reuters in an interview that a modest rise in the debt ceiling could be a sign that Washington's final budget agreement will not be enough to meaningfully cut the U.S. deficit.
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