WASHINGTON (Reuters) - The fiery debate over extending tax cuts for the wealthiest Americans has diverted attention in Washington from a major issue for investors -- a potential rise in taxes on dividends and capital gains.

With U.S. congressional elections just seven weeks away and voters in a sour mood over a slow economic recovery, Democrats and Republicans are arguing over whether to renew Bush-era tax cuts for all Americans or just the middle class.

If Congress does not act, income taxes will rise next year -- and so will the rate on dividends, to as much as 40 percent from the current 15 percent.

The uncertainty is making investors wary and companies that pay dividends are lobbying hard to keep the rates low.

“It’s our top issue between now and the end of the year,” said Duke Energy Corp spokesman Tom Williams.

Energy, utility and telecommunications companies are among those most affected by the potential changes because they tend to pay the highest yields.

Individuals who earn more than $200,000 per year now pay 15 percent tax on dividends. President Barack Obama, a Democrat, wants the dividend rate raised to 20 percent, while Republicans and companies want to keep it at 15 percent. If they fail to reach a deal, the dividend rate shoots up to about 40 percent.

Capital gains are now taxed at 15 percent. Obama wants the rate to be 20 percent but it faces no jump to 40 percent.

The Edison Electric Institute, which represents energy firms, is so fearful over the dividend issue that it agreed to accept Obama’s 20 percent rate to avoid the 40 percent.

“That is certainly a position we could be comfortable with,” EEI spokesman Jim Owen said, while stressing that his group prefers the 15 percent rate.

“Utilities are in relatively early stages of a major long-term infrastructure build-out and we’re going to need to generate a lot of capital,” Owen said. “We would rather do it from an equity rather than a debt position.”

COMPROMISE OR DOOMSDAY?

The possibility of a one- or two-year renewal of all of the Bush-era income tax rates -- an idea embraced by Republicans and some Democrats -- has gained currency in recent weeks.

Such a deal would benefit investors as it would extend the 15 percent rate for both capital gains and dividends.

A potential compromise is to trade a lower dividend tax rate for a slight increase in the capital gains rate, according to those familiar with the discussions.

No decisions have been made as lawmakers have just returned from the August recess and will resume talks this week.

Complicating matters are congressional budget rules that require lawmakers to find tens of billions of dollars in new federal dollars to extend the Bush tax cuts on dividends and capital gains.

By contrast, tax cuts for middle income households can be extended without finding offsetting revenue.

“My gut reaction is they probably haven’t figured it out,” said Mark Bloomfield, president of the American Council for Capital Formation, a group backed by companies opposing higher investment-income taxes.

“If you extend it for a year, you don’t have to address that issue” or arguments from companies that higher rates will derail the economic recovery, he said.

Even so, investors should brace for the doomsday scenario of congressional impasse and 40 percent dividend taxes, said James Lucier of Capital Alpha Partners, an analyst specializing in the impact of U.S. laws and regulation on businesses.

“We retain our contrarian position that gridlock will prevail and that the tax issue will bleed over to next year,” Lucier said.