UPDATE 3-Merkel slashes budget to tame deficit by 2013

Mon Jun 7, 2010 9:25pm IST

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* Merkel coalition agrees 11.2 bln euros savings in 2011

* Targets 80 billion euros of budget measures by 2014

* No hikes in income tax or VAT; federal jobs to go

(Adds official numbers, quotes, analysts' comments)

By Stephen Brown and Dave Graham

BERLIN, June 7 (Reuters) - German Chancellor Angela Merkel's coalition agreed a package of budget cuts and taxes on Monday to bring the structural deficit of Europe's biggest economy within EU limits by 2013 and revive her political fortunes.

The measures, touted as Germany's biggest austerity drive since World War Two, aim to deliver savings of 11.2 billion euros next year and lower a deficit set to exceed 5 percent of gross domestic product (GDP) this year, according to an official draft of the plan.

Planned savings will rise to 19.1 billion euros in 2012, 24.7 billion euros in 2013 and 26.6 billion the following year, according to the plans. This is expected to reduce the deficit to below the EU limit of 3 percent of GDP.

"We must save about 80 billion euros by 2014 so that our finances can stand on their own two feet in the future," Merkel told a news conference after a two-day budget conclave.

"The last few months have shown, together with Greece and other euro states, how important it is to have solid finances," said Merkel, who must get the savings package through parliament at a time when her popularity is sliding in opinion polls.

Guido Westerwelle, the head of Merkel's coalition partners the Free Democrats (FDP), said the German government faced a Herculean task.

"Eighty billion euros can't be saved with a pair of nail clippers," said Westerwelle, whose popularity has fallen even more, making him a liability as a partner for Merkel, who ruled until 2009 in a "grand coalition" with the centre-left Social Democrats.

Westerwelle presented slightly different figures at the news conference, based on different budget assumptions.

PRESSURE TO SPEND, NOT SAVE

Merkel's new government took power in October vowing to slash taxes, but the euro zone crisis and debt-brake legislation introduced by her prior coalition has forced it to abandon those plans and even consider limited tax hikes.

In the end, her government avoided raising income tax or eliminating discounted value-added tax (VAT) rates for certain products -- a step some members of her party had supported but many economists had warned against.

"It's encouraging that they renounced broad tax hikes, which would have been the wrong way to go as consolidation via revenue does not work," said Unicredit economist Andreas Rees.

Merkel acknowledged that Germany was under international pressure "to spend more in the current situation" in order to boost demand.

European partners like France have openly chastised Berlin in recent months for adopting policies they say dampen consumption in Germany and aggravate imbalances within the 16-nation euro zone.

The government proposes saving 30 billion euros over the next four years in welfare, mainly from unemployment benefits, and slashing thousands of federal government jobs.

"The German labour market has come through the crisis relatively unscathed. So the German state can handle job cuts better than Spain, for example, where unemployment is very high," said BHF Bank economist Uwe Angenendt.

The Defence Ministry will also study the feasibility of cutting 40,000 jobs in the armed forces, after proposals to scrap national service sparked fierce debate in the coalition.

On the revenue side, the German government wants to raise an extra 2.3 billion euros per year by taxing the profits of nuclear power station operators and introducing an "environmental" tax on domestic air travel.

A financial transaction tax would raise 2 billion euros a year from 2012, Merkel estimated. She said the chances of such a tax being imposed Europe-wide were "not bad".

The government said it would stick with plans to raise spending on research and development by 12 billion euros by 2013.

UPPER HOUSE PROBLEM

Merkel hopes the package can help restore faith in her leadership. Her image has taken a beating in recent months amid coalition infighting and accusations she mismanaged the euro zone crisis by delaying aid for Greece.

Now she must convince parliament and German unions to back the cuts. Her coalition lost its majority in the Bundesrat upper house after a regional election setback last month, making her task all the more difficult.

Tempers are flaring in her own coalition between Bavaria's Christian Social Union (CSU) -- sister party to her own Christian Democrats (CDU) -- and the pro-business FDP.

Last week, the CSU torpedoed plans for a flagship health reform drawn up by the FDP health minister, infuriating the FDP.

Compounding her problems, influential German media, including Der Spiegel weekly and the mass-circulation Bild daily, have come out in support of an opposition candidate for president, meaning Merkel may face a battle to get her own choice elected on June 30. (Additional reporting by Matthias Sobolewski, Andreas Rinke and Sarah Marsh; writing by Stephen Brown and Madeline Chambers; editing by Noah Barkin)

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