Republicans and Democrats grappled over the government's annual spending levels on Tuesday as they worked toward a deal that would narrow annual budget deficits and allow the country to continue borrowing at rock-bottom rates.

As Vice President Joe Biden met with top lawmakers at the Capitol, the chairman of the Federal Reserve warned that failure to lift the government's borrowing limit could risk a potentially disastrous loss of confidence, underscoring the high stakes behind the deficit-reduction talks.

The group has struggled so far to breach a stark divide over taxes and healthcare, but could find common ground on a proposed multi-year freeze to the annual spending that covers everything from law enforcement to space exploration.

President Barack Obama and Republicans both back a freeze, but Republicans want to lock in spending at a much lower level. The difference amounts to more than $1 trillion over 10 years -- a gap that will not be easy to resolve.

Obviously the baseline is a big part of it, said Democratic Representative Chris Van Hollen.

The group has stepped up the pace of its talks to try to reach a deficit-cutting deal that would give Congress the political cover to raise the $14.3 trillion debt limit well before August 2, when the Treasury Department has warned it will run out of money to pay the government's bills.

The United States could lose its top-notch credit rating and the dollar's reserve-currency status could suffer if Congress does not act, Federal Reserve Chairman Ben Bernanke warned.

Even a short suspension of payments on principal or interest on the Treasury's debt obligations could cause severe disruptions in financial markets and the payments system, Bernanke said at an event sponsored by the Committee for a Responsible Federal Budget.

GET IT OVER WITH

Republicans say any increase in the debt limit must include spending cuts equal in size. That would mean cuts of at least $2 trillion to ensure Congress does not have to revisit the politically toxic issue before the November 2012 elections.

We'd like to do it all at once, you'd hate to have to come back and do it in pieces, said Republican Senator Jon Kyl.

On Wednesday at 9:00 EDT (1300 GMT), the group is expected to consider proposals that would trigger automatic spending cuts, and possibly tax hikes, if Congress does not get budget deficits under control in coming years. Republicans want a firm cap on spending, while Democrats favor a more flexible approach that would allow tax hikes as well.

We're making real progress, we're down to the tough stuff now and everybody's still in the room, Biden said after the meeting.

Republicans have consistently said tax increases are off the table, but a vote in the Senate indicated that many would be willing to close certain tax breaks to reduce the deficit. Some 34 of the chamber's 43 Republicans voted to cut subsidies for the ethanol industry, but the measure failed as Democrats opposed it on procedural grounds.

Democrats have resisted changes to popular health benefits that are projected to grow sharply in coming decades. But they might consider changes if Republicans show flexibility on taxes, a Democratic congressional aide said.

Obama and House of Representatives Speaker John Boehner, the top Republican in Congress, want the group to complete its work by July 4, well before the Treasury's August 2 deadline, to avoid spooking financial markets.

We could actually have a reprise of a financial crisis, if we play this too close to the line. So we're going be working hard over the next month, Obama said on NBC television.

Deficits are hovering at their highest levels relative to the economy since World War Two. For this fiscal year, the deficit is expected to reach $1.4 trillion.

Congress faces the challenge of trying to cut the budget but also boost the sputtering economy in the short term.

The White House is weighing a payroll tax cut for businesses and Republicans are touting a job-creation agenda of that consists of tax cuts and scaled-back regulation.

(Additional reporting by Richard Cowan, Donna Smith, Pedro DaCosta and Matt Spetalnick; Editing by Eric Walsh and Christopher Wilson)

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