* Conservatives say Treasury could pay some bills and not others
* Prioritizing payments hit by critics as unworkable
By Kim Dixon and Rachelle Younglai
WASHINGTON, Jan 15 (Reuters) - Republican lawmakers are preparing to introduce legislation to direct the U.S. Treasury to make interest payments on U.S. bonds first and then prioritize other government outlays in case Congress does not raise the debt ceiling.
Supporters of the idea see it as a politically palatable alternative to default, which could rattle markets as occurred in the summer of 2011. The likelihood of another market-unsettling event is challenging Republicans to find another idea as they use the debt ceiling as leverage to extract spending cuts from President Barack Obama.
But critics, including some Republicans, say prioritizing payments is largely unworkable and would not fool the markets.
The Treasury hit the $16.4 trillion debt ceiling, or the legal amount it is allowed to borrow, on New Year's Eve and started moving funds around so that the government can continue paying its bills. But the department said it will run out of funds as early as mid-February.
Among those advocating the approach is Republican Senator Pat Toomey of Pennsylvania, who is expected to reintroduce legislation next week to instruct the Treasury to make sure bondholders got paid first if Congress does not raise the debt ceiling by the deadline.
In the House of Representatives, Arizona Republican David Schweikert introduced legislation that would force the Treasury to prioritize payments to bondholders, Social Security recipients and military salaries.
"No one is talking about default except for the president," said Patrick Tiberi, a Republican Representative from Ohio who heads a tax-writing subcommittee.
"He doesn't need to default because he has enough revenue, money coming in from the taxes that you guys pay to pay bills," Tiberi told reporters Tuesday.
"Ninety-nine percent of my constituents would say that sending out Social Security payments and keeping veteran hospitals open is a bigger priority than national parks," he said.
But former advisers to Republican President George W. Bush say the idea is unworkable for a number of reasons, including the fact that tax revenue does not come in at the same rate that payments are due.
"Prioritization is impossible," said Tony Fratto, who was Deputy Press Secretary for Bush and a spokesman on economic policy who fought through approximately seven debt limit increases with Congress.
"Is the government really going to be in the position of withholding benefits, salaries, rent, contract payments etc., in order to pay off Treasury bondholders? That would be a political catastrophe," Fratto said.
INCREASED CREDIT RISK
Keith Hennessey, Bush's National Economic Council director, said prioritization was a bad idea that could increase credit risk and said it would be irresponsible.
"Payment prioritization doesn't stop payments, it just delays them. Then the aggrieved party sues the government, and probably wins, and it turns into a bloody mess," Hennessey, now an economist at Stanford, said in a blog post this week.
Even when the government was operating under a budget surplus, as it did from 1998 through 2001 under President Bill Clinton, the Treasury still had to borrow or issue debt to make its regular payments because its income fluctuates month-to-month.
The department is expected to run out of ways to stave off a default as early as mid-February, and Republican lawmakers say they will refuse to give the Obama administration the votes needed to raise the debt cap unless Democrats agree to spending cuts and changes to federal benefits programs
On Feb. 15, the government is expected to take in about $9 billion in revenues and is required to pay bills amounting to $52 billion, according to the think tank the Bipartisan Policy Center, which analyzed Treasury's cash flows.
The Treasury Department has said ensuring that bond investors got paid before others would be a "default by another name."
And in the past, Treasury officials have said the department lacks the formal legal authority to establish priorities to pay obligations, according to the nonpartisan Congressional Research Service.