Extract first n bytes from .tar.gz and output as a .tar.gz in a single command

Instead of trying to extract the archive’s contents (which can’t work here — there’s no way to track the individual files’ metadata), decompress it, truncate it and recompress it. If you have a version of head capable of this:

gzip -dc input.tar.gz | head -c128M | gzip -c > final.tar.gz

or you can use dd as in your command:

gzip -dc input.tar.gz | dd bs=1M count=128 iflag=fullblock | gzip -c > final.tar.gz