Capital Gains Pulls GOP, Democrats Apart on Budget

THE peaceful coexistence that George Bush has knitted so carefully with a Congress controlled by Democrats has come unraveled. Negotiations over the federal budget - which is Washington's primary political product - have come apart at the seams over cutting the tax rate on capital gains. Frustration levels are high.

If Congress and the President fail to agree on a budget bill by Oct. 15, then the budget will be cut automatically by an across-the-board formula under the Gramm-Rudman Act.

The automatic cuts appear increasingly likely in the comments of both Republicans and Democrats. Both sides are talking tough about standing their ground, although no one seems to have arrived at this stage through any coherent strategy, according to lobbyists and observers with close ties to political leaders.

``I'm more impressed with the lack of strategy,'' says Rudolf Penner, former director of the Congressional Budget Office. ``I think we've reached this state because of immense confusion.''

The Gramm-Rudman ax bodes somewhat worse for Republicans than for Democrats.

The nearly $17 billion that would be cut from the federal budget would be taken half from defense programs and half from nondefense programs. The Office of Management and Budget estimates that would mean a 4.3 percent cut in defense and 5.3 percent from other categories.

Defense would be hit harder, however, since the law leaves little flexibility in how it is cut. Nondefense spending cuts are allowed more room for maneuver, and Social Security and most welfare programs are exempted.

``Therefore,'' notes Stuart Eizenstat, a Washington lawyer and former domestic policy adviser in the Carter White House, ``it gives the Democrats more of a club with the administration than it gives Bush over them.''

Some, including Robert Litan at the Brookings Institution, say the White House would not mind the automatic cuts in the end. It would get Bush through his first year without a tax hike, he notes, and ``they can live through one year of this.''

The relationship between Bush and Congress is by no means beyond repair, given the fence-mending temperament of the president and current congressional leaders. But for now the talk is growing sharper.

White House spokesman Marlin Fitzwater last week called the outlook for averting Gramm-Rudman cuts ``bleak.'' Senate Budget Committee chairman Lloyd Bentsen (D) of Texas called them ``a very real possibility.''

The snag that is unraveling the whole relationship is the proposed cut in the tax on capital gains. Supported by the administration, the tax break had enough Democratic support to survive the House Ways and Means Committee as part of the budget reconciliation bill.

Both the White House and the Democratic leadership have seized on the issue as a matter of principle.

Bush sees it as a way of promoting investment in the economy while actually giving a short-term boost to the government's tax income because of the sell-offs that a rate cut would encourage. Democratic leaders see the cut as an unequal break for the wealthiest taxpayers.

Many Democrats, among them party chairman Ron Brown, see this as a chance to ``draw a line in the sand'' and stand on the side of the average, less-than-affluent citizen in a clear challenge to the Republicans.

The Democrats themselves are deeply split over capital gains, however, with some prominent Southern Democrats favoring the cut.

The House leaders are scrambling to support an alternative plan for promoting savings and investment - to expand the tax deductibility of individual retirement accounts - that favors more middle-income people than does the more elite capital-gains cut. The plan includes removing a tax rate ``bubble'' that assesses the highest incomes at a lower rate than some merely affluent ones. The Democrats would extend the top marginal tax rate of 33 percent to the highest incomes as well.

Mr. Bush continues to oppose such a tax increase.