A key Senate committee has approved a radically reduced tax cut in an attempt to appeal to Republican moderates.
The changes to President Bush's $550bn (£343bn) tax cut plan - the centrepiece of his domestic policy agenda - were approved by 12 votes to nine in the Senate finance committee.
The carefully crafted compromise, designed to appeal to Republican and Democratic moderates alike, dramatically reduces Mr Bush's proposed abolition of taxes on dividends.
Bush rejects a 'little bitty' tax cuts package
With the House also writing a bill which reduces the dividend tax cut, President Bush's plan is likely to be substantially scaled back.
The Senate finance committee chairman, Charles Grassley, had already promised a group of Republican rebels that the total tax cut would come to no more than $350bn.
They feared that otherwise, the spiralling federal deficit would get out of control.
Senator Grassley won the support of the key Republican rebels by proposing a modest reduction in the tax on stock dividends in return for crackdowns on tax loopholes.
President Bush's plan to abolish the tax on dividends was the centrepiece of his proposal, at a cost of $350bn.
But Mr Grassley's plan allows only a deduction on the first $500 of dividend income, at a cost of $80bn.
That would be paid for by higher user fees for customs imports and increased taxes for Americans who work and live abroad.
Mr Grassley has also proposed $20bn to help the individual state governments deal with their own growing budget deficits - a move designed to appeal to moderate Democrats.
Senator Olympia Snowe of Maine, a key Republican opponent of the Bush tax cuts package, praised the deal, saying that "the fiscally responsible growth policies contained in this package meet the dual challenge of immediate, stimulative economic growth, without further ballooning deficits".
But White House spokesman Ari Fleischer said "the action taken in the finance committee on dividends - and dividends alone - is insufficient, but it is progress".
President Bush continues to criss-cross the country, urging Congress to reject a "little bitty" tax package and attacking Democratic Senators who have opposed his plans.
He argues that the bigger the tax cut, the more effective it will be in creating jobs.
Meanwhile, the more right-wing House of Representatives has adopted a completely different approach, with its tax-writing committee proposing to cut taxes on both dividends and capital gains in half - but not eliminate them.
Republicans, such as Senator Rick Santorum argue that this recession has been caused by weakness in business investment, not consumer spending, and tax cuts should be aimed at helping businesses.
Democrats, meanwhile, argue that the tax cuts are aimed far too much at the rich, and want a smaller package targeted at middle income families and more help for the unemployed.
And two Senators on the committee, who are both running for the Democratic nomination for president, offered their own plans for reviving the economy.
Senator John Kerry said that the country would pay a high price for the "ideological gridlock" in the Senate, with 54% of the tax cut going to those earning more than $350,000.
Senator Bob Graham proposed a refundable tax credit and the postponement of tax cuts for top income groups.
Now the tax bill could face a further fight on the floor of the Senate or in the committee that will have to reconcile the two versions of the legislation passed by the different chambers.
Passing a tax bill this year is vital to Mr Bush's re-election hopes, as he wants to show the electorate that he takes their concerns about the economy seriously.
But in the highly partisan and deeply divided Congress, where the Republicans hold only a wafer-thin majority in the Senate, that is proving a difficult business.
Meanwhile, pressure on the budget deficit continues to grow.
The latest government figures show that this year's deficit could top $500bn, the largest in history, with tax revenue is running $100bn lower than expected.