Leaders of Germany's proposed grand coalition have ruled out broad-ranging tax cuts for the next four years, a move that prompted questions over the new government's courage to confront the need for economic reforms.

The decision represents a policy U-turn by chancellor-in-waiting Angela Merkel, who promised during her election campaign to cut the basic tax rate from 15 to 12 per cent and the top rate from 42 to 39 per cent.

Eckart Tuchtfeld, an economist with Commerzbank in Frankfurt, said it was "alarming that, from the very beginning of the coalition negotiations, there was agreement on what cannot - rather than on what can - be done. This is a very defensive approach".

The BDI, Germany's main industry federation, said tax cuts were "necessary, especially for business, in order to receive a positive signal from the grand coalition to encourage new investment in Germany".

The agreement on a tax cut policy between the Social Democratic Party (SPD) and the Christian Democratic Union (CDU) came after their first round of coalition negotiations in Berlin.

Ronald Pofalla, deputy leader of the CDU parliamentary group, said the decision was necessary to focus on cutting Germany's budget deficit to below 3 per cent of gross domestic product by 2007, thereby bringing it into line with the European Union's fiscal rules.

"This has to be our priority," he said yesterday.

He stressed that corporate tax cuts were still likely, but would have to be financed via the closure of tax loopholes and subsidies, such as those offered to homebuilders and commuters

Coalition politicians said that a corporate tax rate of 19-22 per cent was likely, down from 25 per cent today, if agreement could be reached on cross-financing the cut.

Steps to simplify Germany's complex tax rule book would also be part of the coalition agreement expected in mid-November, Mr Pofalla said.

Economists and opposition parties have warned that a grand coalition could lead to a stagnation in the country's economic reform process due to a clash of policy priorities between Germany's two largest parties.

The opposition liberal Free Democrats said yesterday that this process had already taken hold. "To refrain from a clear tax-cutting agenda is a step in the wrong direction. The new beginning that Germans had hoped for is already being negotiated away by the grand coalition," a spokesman said.

Klaus Zimmermann, president of Berlin's DIW economic research institute, was more positive, arguing that the decision not to reduce income taxes was "correct, as there is no money for tax cuts and budget consolidation must be the priority".

He said the CDU "had finally become realistic about what steps were necessary to meet the EU stability pact criteria".

He said tax increases, such as a rise in consumption tax, would be necessary to pay for cuts in employers' non-wage labour costs, adding that he expected such a rise to be part of the coalition agreement.

The CDU is in favour of such an increase and SPD politicians signalled that they might support such a move. The BDI said that a consumption tax increase would be very damaging for business. - (Financial Times Service)