* CBO sees $845 bln deficit for FY 2013, $616 bln for FY 2014
* Deficits start to grow again by mid-decade; debt keeps mounting
* CBO forecasts assume automatic spending cuts happen as planned
By David Lawder
WASHINGTON, Feb 5 (Reuters) - The U.S. budget deficit will drop below $1 trillion this year for the first time during Barack Obama's presidency, the Congressional Budget Office said on Tuesday, but it warned that debt will swell to unsustainable levels without further action by lawmakers.
CBO forecast that the deficit for fiscal 2013, which ends Sept. 30, will shrink slightly to $845 billion after four straight years above $1 trillion. The reason is an improving economy and higher taxes paid by wealthy Americans.
The CBO analysis, which will feed into Congress' bitter debate over how to tame deficits, assumes that $85 billion in automatic spending cuts will launch as scheduled on March 1.
It said the fiscal tightening from those across-the-board cuts and from higher taxes will slow economic growth to an anemic 1.4 percent by the end of 2013, causing the unemployment rate to edge higher to 8.0 percent by then from about 7.9 percent currently.
The analysis is the first from the non-partisan budget agency to incorporate the New Year's deal to avert the "fiscal cliff," which restored pre-2001 tax rates on income above $450,000 for couples and let a temporary payroll tax reduction expire. The automatic spending cuts were only delayed for two months until March 1.
But after absorbing these headwinds, the economy will regain momentum in 2014 and fill federal coffers at a faster pace, even without further spending cuts or tax hikes, CBO said. It forecast a $616 billion deficit in fiscal 2014 and a $430 billion deficit in fiscal 2015, equivalent to 2.4 percent of U.S. gross domestic product at that time, a level that many economists view as sustainable.
But deficits will rise steadily from mid-decade, nearing $1 trillion again by 2023, according to the forecast. The 10-year cumulative deficit is forecast at $6.958 trillion.
"Deficits are projected to increase later in the coming decade, however, because of the pressures of an aging population, rising health care costs, an expansion of federal subsidies for health insurance, and growing interest payments on federal debt," the CBO said in the report.
DEBT LOAD MOUNTS
The CBO warned that U.S. debt held by the public would continue to mount, staying at the highest levels as a percentage of GDP since about 1950 through the next decade, reaching 77 percent of GDP by 2023.
It argued that this would crowd out private investment and seriously limit lawmakers' flexibility to deal with challenges such as a new recession or a future war.
"Such a large debt would increase the risk of a financial crisis, during which investors would lose so much confidence in the government's ability to manage its budget that the government would be unable to borrow at affordable rates," the CBO said.
Republicans seized upon the report as evidence that their worst fears -- a European-style debt crisis - will come true without deep spending cuts to expensive health care programs such as Medicare and Medicaid.
"The CBO's report is yet another warning that we need to get spending under control. The deficit is still unsustainable," Paul Ryan, the House Budget Committee Chairman and former Republican vice presidential candidate, said in a statement.
"By 2023, our national debt will hit $26 trillion. We can't let that happen. We need to budget responsibly, so we can keep our commitments and expand opportunity," Ryan said.
Democrats put the emphasis on the progress made in reducing deficits and in fostering economic recovery.
"The report confirms that the economy has made important progress over the last few years, but there is clearly more to do," said Representative Chris Van Hollen, the top Democrat on the House Budget Committee. "Our first priority must be putting Americans back to work, but unfortunately, congressional Republicans have blocked progress at every turn.
The report comes as President Barack Obama called for another temporary delay in the automatic spending cuts, an overture that was quickly rebuffed by House Republicans.
If Congress were simply to cancel the cuts with no savings to offset them, that would add about $1.2 trillion to the cumulative projected 10-year deficit, pushing it to over $8 trillion.
Republicans in the House of Representatives are preparing a budget that aims to achieve balance within 10 years - a phenomenon not seen since 2001.
In a separate report, CBO said that would require about $4 trillion in additional fiscal tightening through tax hikes, spending cuts or both over the next decade -- while leaving in place or replacing the automatic sequester cuts.
It forecast that if $4 trillion in additional 10-year budget savings were achieved, output would be reduced by 0.6 percentage point in 2014 compared with its current-law "baseline." But it would add 1.7 percentage points to growth in 2023 by reducing debt service costs and freeing up investment capital.
A more modest deficit reduction plan of $2 trillion also would have some near-term pain and long-term gain, reducing 2014 growth by 0.3 percentage point, while adding 0.9 percentage point to 2023 growth.
FED MAY RUN DRY
The CBO also forecast that a major cash cow for the government in recent years - the Federal Reserve - could run dry as a revenue source in about five years.
Flush with earnings from the massive bond holdings it has accumulated to hold down interest rates, the Fed is expected to contribute some $95 billion a year to federal coffers through 2016. But these will drop off quickly as the U.S. central bank unwinds its holdings and takes some capital losses as rates rise, CBO says. Such remittances are projected to fall to zero between 2018 and 2020, resuming again in 2021 at lower levels.
Interest rates for benchmark 10-year U.S. Treasury notes will average 2.1 percent this year and stay below 3 percent in 2014, but will start to rise thereafter, averaging 4.5 percent in the 2015-2018 period, CBO projects.