UPDATE 4-Obama challenges Republicans to keep tax cuts for middle class

* Attempts to shift campaign debate away from jobs

* Republicans: move will hurt small businesses

* Democrats split over how to address the issue

By Jeff Mason and Alister Bull

WASHINGTON, July 9 (Reuters) - President Barack Obama called on Monday for a one-year extension of Bush-era tax cuts for families earning less than $250,000 a year, seeking to steer the election-year debate away from high unemployment and portray himself as a champion of ordinary Americans.

The tax proposal is unlikely to sway Obama's Republican opponents in Congress, who argue that the cuts should be maintained for everyone, including higher earners.

Obama said both sides agree on the need to keep tax rates down for middle income groups at least.

"Let's not hold the vast majority of Americans and our entire economy hostage while we debate the merits of another tax cut for the wealthy," Obama said at the White House, standing in front of a riser filled with people who he said would be hurt if their tax cuts were not extended.

"We can have that debate, but let's not hold up working on the thing that we already agree on."

Whether it gains traction or not, the Democratic incumbent's appeal achieves several goals as the campaign heats up ahead of the Nov. 6 general election.

It shifts the conversation - at least for a day - from last week's meager jobs report and his handling of the economy to "tax fairness" and inequality.

It burnishes Obama's message of being the candidate who backs the middle class while Republicans and their presidential hopeful, Mitt Romney, are out of touch with ordinary people and favor the wealthy.

Democrats have hit that message hard in recent days as they call on Romney to release more tax returns and give details of holdings in foreign tax havens like Bermuda, the Cayman Islands and Switzerland.

Obama's tax announcement also sets a baseline for what is likely to be a months-long debate about deficit reduction in the campaign. Polls show the economy is the issue that worries voters most, and that Obama and Romney are running a close race.

ROMNEY REACTION, FISCAL CLIFF

Republicans charge that allowing taxes to rise for wealthier Americans would hurt small business owners who are helping to create jobs in a tough economy, but Obama tried to neutralize that argument by saying 97 percent of all U.S. small business owners would fall under the $250,000-a-year income threshold.

"This isn't about taxing job creators, this is about helping job creators," Obama said.

The tax cuts enacted by Republican President George W. Bush, Obama's predecessor, will expire on Jan. 1 without congressional action, increasing fears that the United States will go over a so-called fiscal cliff as deep public spending cuts also kick in.

Romney's campaign said on Monday that Obama's tax proposal would amount to a "massive tax increase" on families, job creators and small businesses.

"It just proves again that the president doesn't have a clue how to get America working again and help the middle class," Romney spokeswoman Andrea Saul said.

Obama's move holds political pitfalls as his fellow Democrats are divided about how to address the issue.

House of Representatives Democratic leader Nancy Pelosi has suggested that the income threshold for extending tax cuts be set at $1 million a year. Some Democrats oppose any extension, while others are wary of allowing taxes to rise for higher earners because of its economic impact.

Democratic strategist Doug Hattaway, an adviser to Hillary Clinton when she ran for president in 2008, said Obama's plan was a good strategy.

"Middle-class families drive the economy and middle-class voters will decide the election," he said. "This helps the president continue to tell the story that he's doing everything he can for them, while Romney ships their jobs overseas."

Obama agreed to a two-year extension of all of the Bush tax cuts that went into effect last year. Senate Republican leader Mitch McConnell said on Sunday the economy was worse now than it was when the parties agreed to the last extension. He argued for extending all of the cuts for a year.

White House spokesman Jay Carney said Obama would not sign a bill that extended tax cuts for all income groups.

The expiring tax cuts set up what could be another deeply partisan fight in Congress, where Republicans hold the House and Obama's fellow Democrats narrowly hold the Senate.

Obama will campaign in the battleground state of Iowa on Tuesday, where he will promote his tax proposal and seek to draw a sharp contrast over the issue with Romney.