A cornerstone of President Obama's jobs package is its efforts to encourage new investments in the country's infrastructure. But state and local leaders say one of the changes it makes to the country’s tax system would actually make it more difficult for governments to finance those very same projects.

States and localities issue municipal bonds when they need to borrow money to fund everything from roads to sewage systems. But investors don’t pay federal taxes on their earnings from those bonds, and as a result, governments can get away with paying investors a lower interest rate than they otherwise would.

To help pay for the jobs plan, Obama has proposed capping tax-free exemptions for the country’s highest earners. Americans in the top tax bracket would pay 7 percent on any income that would have otherwise been tax-exempt, including municipal bonds. If the Bush tax cuts expire at the end of 2012, the maximum tax on municipal earnings would be even higher: 11.6 percent.

State advocates and the finance community both say that proposal is misguided, because if investors have to start paying taxes on municipal bonds, state and local governments will simply have to pay them a higher interest rate to make up that difference, making it more expensive for them to finance projects. And that increased cost of borrowing would be passed on to state and local taxpayers.

"I think people haven't really thought through very well how this actually works," says Bill Daly, senior vice president for government relations at the industry group Bond Dealers of America.

One could argue that the tax-exempt status for municipal bonds is a subsidy for the wealthy, since their tax-exempt status primarily benefits those in the highest tax brackets. But Daly tells Governing that that's a misconception. He argues that it's state and local taxpayers who benefit, since their governments are currently able to borrow money at a lower rate than they otherwise could because of the exemption.

The problem for municipalities is that any effort to tax muni bond proceeds would throw off the business model for bonds. For example, a municipal bond earning 4.25 percent to an investor in the highest tax bracket would really only earn 3.95 percent after taxes, according to an analysis by Peter Hayes, head of the municipal bond group at BlackRock.

Hayes writes that Obama's policy would have a bigger impact on issuers than investors. "And ultimately, when issuers’ borrowing rates go up, all taxpayers are affected, not only those investing in municipal bonds,” Hayes writes.

Respected strategy firm Municipal Market Advisors (MMA) estimated in a recent report it shared with Governing that the change could collectively cost municipal issuers an extra $600 million per year in interest payments. And that would come at the same time state and local governments will likely be suffering from federal spending cuts as a result of Washington’s deficit reductions efforts. “It’s another whammy,” says Michael Bird, federal affairs counsel for the National Conference of State Legislatures.

Muni market observers blasted the Obama administration for the proposal, even though they don't expect it to gain much momentum. “As far as we can tell, the proposal… occurred almost as an afterthought,” Citigroup Global Markets wrote in a recent report.

MMA put the proposal in more stark terms: “President Obama has now identified an official administration goal in limiting wealthy taxpayers’ benefit from municipals."

Critics of the plan also don’t like the fact that the tax would be applied retroactively to existing investments. Even if the proposal doesn’t go forward, the mere fact that it was made will likely cause muni investors to now consider the potential for retroactive taxes at any time. Those fears will likely increase the cost of borrowing for state and local governments, according to Citi.

The White House referred questions about the proposal to the Office of Management and Budget, which has not responded to Governing's requests.

Municipalities have relied on the tax-exempt status of their bonds for almost 100 years. Even though Obama's plan is unlikely to pass in a hyper-partisan Congress, it’s troublesome that lawmakers are even considering changing the municipal finance mechanism, says Cornelia Chebinou, head of the Washington office of the National Association of Auditors, Comptrollers and Treasurers.

For cities and states, the tax-exempt status of their bonds is considered so important that one Republican-backed bill is using it as a stick, threatening to revoke the tax exemption if jurisdictions don't comply with proposed transparency policies.

Muni experts say they expect that as the country focuses on deficit reduction, many tax exemptions, including those for muni bonds, will continue to be targeted.

Already the National Commission on Fiscal Responsibility and Reform, also known as the Simpson-Bowles commission, proposed revoking the tax-exempt status of muni bond earnings in its report released last year. Sens. Ron Wyden and Judd Gregg also proposed eliminating municipal tax-exempt status last year and instead having a smaller tax credit for a portion of their interest.