President Barack Obama proposed curbing the amount of interest from municipal bonds that top earners can exclude from their taxable income, a step that may diminish demand for state and local-government securities.

The president’s $447 billion job-creation plan would pare the tax break for municipal-bond interest to 28 percent for couples earning more than $250,000 a year. Such tax-exempt interest is currently worth 35 percent for earners in the top tax bracket because that’s the amount they would otherwise have to pay on their income.

Any move to limit the tax advantage for municipal securities would face resistance from local-government officials because the break bolsters demand for their debt, driving down the interest rates they pay when borrowing for public works. Investors in the $2.9 trillion market for municipal bonds are willing to accept lower returns because the income isn’t taxed.

“We’re very much opposed” to limiting the tax exemption, said Mike Nicholas, chief executive of the Bond Dealers of America, a Washington-based lobbying group for banks that underwrite municipal bonds. “You’re going to end up punishing state and local governments.”

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States, cities and counties have yet to fully recover from the strains of the 18-month recession that ended in June 2009. States faced budget deficits of about $89 billion this fiscal year, according to the National Conference of State Legislatures. State and local governments combined have cut 680,000 jobs since 2008, according to Labor Department statistics.

Previous Challenges

The tax break has faced challenges in Congress amid a push to rein in the federal deficit, though no proposals have advanced. The president’s deficit-reduction commission recommended scrapping it last year as part of an overhaul of the U.S. tax code, while Senator Ron Wyden, a Democrat from Oregon, proposed replacing the tax exemption with a credit.

The president’s proposal is narrower and would only limit the benefits, not revoke them entirely, for those in the top tax brackets. It is part of a group of tax breaks targeted to pay for a plan designed to stimulate the economy in part by providing states with aid to keep teachers and emergency workers on the job.

The proposed change was included on page 136 of the 155- page bill and wasn’t trumpeted by the administration. The changes were confirmed by Sandra Salstrom, a Treasury spokeswoman. The measure would take effect at the start of 2013, according to a summary from the administration.

35 Percent

The measure would limit the value of the tax break to the benefit it affords to earners in the 28 percent bracket. That would have a more modest impact than repealing it outright. The exemption effectively provides a 35 percent tax break for top earners because that’s what they pay on other income. For couples earning less than $250,000, or individuals below $200,000 for single taxpayers, there would be no change, said Meg Reilly, a spokeswoman for the White House Office of Management and Budget.

The Government Finance Officers Association, which represents public borrowers, said it was concerned about any move to limit the tax exemption for municipal securities.

“Limiting the amount of tax-exempt interest that can be deducted would likely affect demand and therefore increase debt- issuance costs for all governments who need to access the bond market,” said Susan Gaffney, a lobbyist in Washington for the group.

Victoria Rostow, who follows government affairs for the National Association of Bond Lawyers in Washington, said the inclusion of the exemption with other targeted tax breaks was a surprise.

“It came out of the blue,” she said. “The budget pressures on state and local government provide a very compelling reason to keep it.”