WASHINGTON — President Obama has sent draft legislation to the congressional deficit reduction committee that would have the potential to further limit the value of tax-exempt interest for higher-income taxpayers below the 28% level proposed in his jobs bill.

The 284-page Debt Reduction Act of 2011, which nonprofit publisher Tax Analysts released this week saying it was a draft circulating among lobbyists, would require the Office of Management and Budget to establish steadily declining annual ratios for debt as a percentage of gross domestic product beginning with fiscal 2013.

If the ratios were not met in any given year, automatic cuts in spending and tax preferences, such as tax-exempt interest, would be triggered.

“It would introduce a tremendous amount of uncertainly in the municipal market,” said Bill Daly, senior vice president for government relations at Bond Dealers of America. “Investors would exact a premium on state and local governments because of the uncertainty. It could also discourage trading during the time of uncertainty.”

“It would make tax planning almost impossible,” said Michael Decker, managing director at the Securities Industry and Financial Markets Association and co-head of its municipal securities division. “If you were buying a long-term bond you’d have no idea over the life of the investment how much would be taxed. It would create a big new element of risk that would be difficult to price.”

He said the proposal “is almost worse” than the one in the American Jobs Act of 2011, which would limit the value of tax-exempt interest, along with other tax expenditures and deductions, to 28% for individuals with more than $200,000 of taxable income and couples with more than $250,000.

Edward Kleinbard, a law professor at University of Southern California Gould School of Law and former chief of staff for the Joint Tax Committee, agreed. “It’s one thing to say that the tax benefits of muni bond interest will be capped at a 28% rate from now on,” he said. “It’s another to say the tax benefit will never be more than that available to a 28% taxpayer, but can fluctuate all the way down to zero, depending on unrelated budget disagreements.”

The 28% limit in the jobs bill is viewed by most market participants as a 7% tax on muni bond interest because the highest income tax rate is currently 35%. If the Bush tax cuts expire at the end of 2012, 39.6% becomes the highest income tax rate and the 28% limit would equate to an 11.6% tax on muni bond interest.

For those market participants who thought the job’s bill provision on tax-exempt interest was an aberration because it had never been included in previous proposals to limit tax deductions, Obama’s debt reduction bill continues the theme, threatening to go lower.

“It’s an extension of the same concept in the jobs act. They’re clearly very serious about it,” Daly said.

Lobbyists said the debt reduction bill has been sent to the deficit reduction committee and follows through on the president’s promise to send Congress legislation that would further reduce the deficit beyond the $1.2 to $1.5 trillion mandated for the panel, as well as stabilize U.S. debt as a share of economy.

The deficit reduction bill would require the OMB to set debt-to-GDP ratios that are 0.2 percentage points lower each year. So if the debt-to-GDP ratio is 77.5 for fiscal 2013, as has been estimated by the OMB, the target ratio would be 77.3 for fiscal 2014, said G. William Hoagland, CIGNA’s vice president for federal affairs policy and top budget aide to former Senate Majority Leader Bill Frist.

The OMB would be required to write annual reports within 14 days of the end of each congressional session on whether the debt ratio targets were met and, if they were not, the amount of sequestration or spending cuts triggered.

The bill specifies that half the spending cuts would come from outlays and half from tax expenditures, including tax-exempt interest. The Treasury Department would determine the rate at which the value of tax-exempt bonds and other expenditures would be limited and would promulgate rules to make that rate effective. The process would repeat every year.

Hoagland said he believes administration officials would say that if all of Obama’s proposals in the jobs bill and this bill were passed, sequestration would never occur.

But he and other tax and bond experts all agreed that, regardless of whether Congress passes the jobs bill, if the debt bill were enacted, the limit on the value of tax-exempt interest could be set at any level and could change every year.

“It would mean the market for tax-exempt bonds, on top of everything else, would have to project whether the sequestration trigger would be hit,” said Kleinbard. “It would create an extraordinarily strange market for tax-exempt bonds. It would be a challenge for the market.”

“It’s very clear that the mechanism that would be established here could trigger another reduction in tax expenditures if Congress did not enact legislation that the administration estimates would reduce the debt-to-GDP ratio to 77.3 in fiscal 2014,” Hoagland said.

Daly pointed out that, with the schedules proposed in the bill, the OMB might not submit its annual report to Congress until the end of the calendar year or early the following year. Any needed cuts in tax expenditures would not be determined until after that and would have to be retroactive to the beginning of the year.

But most market participants and other sources do not think the bills will be approved by Congress.

The debt reduction bill is extremely complex. Even if the bills were enacted, Congress has a track record of failing to follow sequestration orders. Lawmakers refused to make large spending cuts in the 1980s under the sequestration provisions of the Gramm-Rudman-Hollings Balanced Budget Act, according to sources.

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