A sweeping U.S. budget deal has brightened the country's fiscal outlook but its gains could evaporate if Congress extends tax breaks in coming years, nonpartisan congressional forecasters said on Wednesday.

Rock-bottom interest rates also will help slash projected budget deficits nearly in half over the next 10 years, the Congressional Budget Office said, and public debt will shrink to 61 percent of the economy over that time period -- roughly the level that economists consider sustainable.

The good news came with plenty of caveats.

Unemployment will hover well above 8 percent and economic growth will remain anemic through the 2012 elections as the country struggles to recover from the deepest recession since the 1930s, CBO said.

Budget deficits will remain high by historical standards as the population ages and healthcare costs continue to rise, the agency said.

And the $3.3 trillion in new budget savings could disappear entirely if Congress opts to extend a range of tax breaks and other temporary fixes, such as higher payments to doctors and hospitals, that are due to expire at the end of 2012.

Democrats want to extend tax cuts that benefit middle and low income taxpayers, while Republicans want to extend those that benefit the wealthiest households as well.

Extending those provisions would worsen budget deficits by as much as $5 trillion over 10 years, CBO said.

I don't want to diminish what has happened, CBO Director Doug Elmendorf said at a news conference, referring to the recent budget deal which accounted for most of the improved fiscal outlook. At the same time there is absolutely no doubt that there are profound budget challenges and economic challenges that remain.

The economic picture is probably worse than outlined by the report as grimmer data has emerged since the agency completed its work in early July, Elmendorf said.

Stocks rose as much as 1 percent and Treasury bond prices fell after the report was released, but other factors then overtook early enthusiasm about the CBO data.

ELECTIONS AHEAD

The report is likely to add fuel to the debate over the economy and the federal budget that is expected to dominate Washington through the November 2012 elections.

President Barack Obama, who is seeking re-election, plans to unveil a job-creation package next month that includes tax breaks and construction spending to prevent the economy from sliding back into recession.

At the same time, lawmakers on a special congressional committee will try to squeeze more budget savings from the tax code and popular benefit programs like Medicare.

That committee was set up by the budget deal that passed earlier this month after months of acrimonious debate.

The deal averted an unprecedented default on U.S. obligations, but still prompted a first-ever downgrade of the country's formerly top-notch credit rating, as ratings agency Standard & Poor's said it fell short of the $4 trillion in savings needed to get the country back on a sustainable path.

The $2.1 trillion in savings called for in the budget deal accounts for the bulk of savings in CBO's new estimate. Reduced interest costs account for much of the rest.

It does indicate that some progress has been made based on the deal the Republicans and Democrats struck earlier this month, White House spokesman Josh Earnest said. The report also makes it clear that there is a lot more that we have to do.

Obama's fellow Democrats said Washington will have to implement both short-term stimulus and long-term austerity in the coming months.

That could be a tough sell with Republicans, who said the new report is further evidence that earlier stimulus measures have not borne fruit.

A slight decrease in the projected deficit is nothing to celebrate, particularly when it is accompanied by the grim news that CBO expects the national unemployment rate to continue to exceed 8 percent well past next year, House of Representatives Speaker John Boehner said in a statement. The president's policies were supposed to keep that from happening.

The unemployment rate, currently at 9.1 percent, will only fall to 8.5 percent by the time voters head to the polls in November 2012, CBO said.

CBO projected the government will post a $1.3 trillion deficit for the current fiscal year, which ends September 30, down from its earlier $1.4 trillion estimate. That would mark the third straight year of trillion-dollar-plus budget deficits.

Gross domestic product will grow by an annual rate of 2.4 percent this year and 2.6 percent next year, CBO said.

(Additional reporting by Richard Cowan in Washington, Chris Sanders in New York and Alister Bull and Laura MacInnis in Martha's Vineyard; editing by Deborah Charles and Vicki Allen)

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