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By Noah Barkin and Paul Carrel
BERLIN (Reuters) - Chancellor Angela Merkel sealed a coalition deal with the Free Democrats (FDP) on Saturday, promising to revive the German economy with billions of euros in tax relief but failing to spell out how the government will pay for the cuts.
The agreement, reached shortly after 2 a.m., paves the way for a new centre-right government to take office next week, roughly a month after Merkel's conservatives and the FDP won a parliamentary majority in a federal election.
The new coalition will look to extend the lifespans of nuclear power plants it judges safe, change banking supervision rules to give the Bundesbank greater powers and ensure continuity in foreign policy, according to the 128-page text.
At the centre of the pact is a pledge to pursue income tax relief of 24 billion euros (22 billion pounds) annually starting in 2011, with low and middle income households and families with children benefiting.
Tweaks will also be made to corporate and inheritance taxes, steps Merkel and her new foreign minister, FDP leader Guido Westerwelle, said would lay a foundation for growth as Germany emerges from its worst recession since World War Two.
"The talks weren't always easy. But they showed we are serious about the challenges ahead and will tackle them with courage and desire," Merkel told a news conference, sitting alongside Westerwelle and Horst Seehofer, the head of the Bavarian Christian Social Union (CSU).
Economists, however, expressed scepticism about how the new government would finance its tax plans, especially in light of a yawning budget deficit, swollen by 81 billion euros in stimulus that was pushed through by Merkel's outgoing "grand coalition" to combat the crisis.
When pressed by reporters on the issue, Merkel said the government expected its measures to boost growth, thus reducing the need for budget consolidation steps. A new "debt brake" law will force the government to make substantial reductions in new borrowing from 2011.
BIG SAVINGS NEEDED
"If the coalition wants to reduce the debt mountain from 2011, then in addition to strong growth they will also need to make savings," said Andreas Rees of Unicredit, who watched the Merkel news conference. "These savings will probably need to be on a big scale."
Some have speculated that Merkel wants to delay announcing tough spending cuts until after an election in the western state of North Rhine-Westphalia, which is scheduled for May 2010.
If her party loses power, her government would no longer enjoy a centre-right majority in the Bundesrat upper house of parliament, allowing opposition parties to block legislation.
The parties also divided up cabinet posts, tapping Wolfgang Schaeuble, a veteran from Merkel's CDU, for the Finance Ministry and Westerwelle as foreign minister.
Schaeuble, 67, a former protege of Helmut Kohl who has earned a reputation as a hardliner on domestic security issues as Merkel's interior minister for the past four years, was a surprise choice.
Before the election, he indirectly criticised Merkel's pledge to pursue billions of euros in tax cuts, saying there was little room for them given Germany's strained finances.
Now he will be charged with implementing those cuts in spite of a deficit that could rise to double EU limits next year.
"The Finance Ministry will be run by Wolfgang Schaeuble because the challenges in this legislative period will be extraordinary," Merkel said. "His experience and abilities, his role in shaping financial policy in the coalition talks, showed he is the right person for the job."
In a wheelchair since he was shot and nearly killed by a mentally ill man in 1990, Schaeuble is an independent-minded politician who will not shy away from pressing his views, even if they are at odds with those of his boss.
The news conference suggested it could take some time for the new coalition partners to get comfortable with each other. The Bavarian leader shifted uneasily in his chair, clearly annoyed with Westerwelle, who interrupted his counterparts on several occasions.
(Additional reporting by Erik Kirschbaum and Sarah Marsh)

Reuters