WASHINGTON — The possibility of a budget compromise between President Obama and Congress to raise income tax rates is more likely than one that would include capping the value of tax exemption for the wealthy, Morgan Stanley Smith Barney told investors Tuesday.

“Although the prospect of ‘capping’ the value of the municipal tax exemption at the level of a 28% tax bracket investor remains, it is by now a familiar concept in the marketplace and one that has gained little traction since its introduction by the Obama administration in late 2011,” John Dillon, MSSB managing director, wrote in note to investors. “It is quite possible that this risk may shadow the municipal market well into 2013.”

Obama first proposed the 28% cap in his jobs bill in 2011 and reintroduced it this year in his fiscal 2013 budget. It didn’t gain momentum in either proposal but rattled muni market participants who said it would increase borrowing costs for state and local governments.

Higher tax rates for taxpayers with adjusted gross income above $200,000 for individuals and $250,000 for families, is more likely an option that lawmakers will consider during budget negotiations over the next seven weeks, Dillon said.

The president and congressional leaders will begin negotiations later this week on a plan to avert the so-called “fiscal cliff” — over $600 billion in tax increases and more than $1 trillion in automatic, across-the-board spending cuts slated to go into effect in January 2013. Both parties have expressed optimism in recent days that a deal can be reached.

“Such a development would be generally constructive with regard to demand for tax-exempt paper,” the firm said in its research note. “Bipartisan post-election rhetoric regarding compromise and ‘reaching across the aisle’ supports the notion of some flexibility on the revenue side of the equation.”

Dillon noted that the compromise rhetoric from policymakers does not appear to be resonating in the marketplace as bond prices continue to rise and equity prices decline.

Meanwhile, the majority of Americans believe that Obama and congressional leaders will not come to an agreement on budget issues and the U.S. economy will go over the fiscal cliff early next year, according to a new poll conducted by the Pew Research Center and The Washington Post.

The poll, published Tuesday, found that 51% of Americans believe the two parties won’t be able to reach a deal on the looming tax hikes and budget cuts set to go into effect at the beginning of January, while only 38% said they will.

If no deal is reached, 53% of Americans would blame congressional Republicans as opposed to 29% who would place the blame on Obama.

While politicians continue to tango over the fiscal cliff, only 26% said they fully understand the consequences of the tax and spending measures to take effect.

More than two-thirds of those surveyed, 68%, said the fiscal cliff would have a “major effect” on the economy and 62% said it would be mostly negative.

The survey was of 1,000 adults conducted between Nov. 8 through 11 and had a margin of error of plus or minus 3.7% percentage points.

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