BERLIN (Reuters) - Germany's main parties sealed an agreement on Friday to create a government of traditional rivals under the leadership of conservative Angela Merkel, breaking eight weeks of deadlock after an inconclusive general election.
"I'm convinced that the coalition creates a genuine opportunity for Germany," said Merkel, who will become the country's first woman chancellor and first from the former communist East if, as expected, the new parliament formally elects her on Nov. 22.
She will head a potentially unwieldy bipartisan government that includes her Christian Democrats (CDU), their Bavarian sister party the Christian Social Union (CSU) and the Social Democrats of outgoing Chancellor Gerhard Schroeder.
But the new government -- only the second "grand coalition" in post-war history -- will be able to operate without crippling opposition from the Bundesrat upper house of parliament, which has blocked reform efforts by previous governments.
In almost a month of relatively harmonious talks, the conservatives and the SPD have bridged differences that bitterly divided them during the campaign.
At the heart of the deal is an agreement to bring Germany's ballooning budget deficit back within European Union borrowing limits by 2007 -- a colossal challenge requiring upwards of 35 billion euros ($40.96 billion) in savings or extra revenues.
A good chunk of that sum will come from higher taxes. The parties agreed on Friday to a controversial 3 percentage point hike in value added tax (VAT) in 2007, an idea championed by the conservatives during the election campaign.
In return for agreeing to the VAT hike, the SPD secured conservative agreement for a so-called "rich tax", which will take the rate for Germans earning 250,000 euros or more up to 45 percent from 42 percent previously.
Economists and leaders of German industry worry the tax rises could hit already weak consumption and prevent the parties from achieving their number one stated priority -- cutting unemployment.
"Never before has a new government hit the public with so many burdens," said Gerd Langguth, a political scientist at Bonn University and biographer of Merkel.
COMPROMISES ON BOTH SIDES
Schroeder, who has led Germany for the past seven years, called for early elections in May as unemployment soared to post-war highs and the electorate grew disillusioned with his reform plans.
He was expected to be trounced by Merkel, whose plans to shake up the German labour market and cut bureaucracy have earned her the nickname "Maggie Merkel" after reform-minded former British Prime Minister Margaret Thatcher.
But a roaring performance from Schroeder on the campaign trail helped his SPD narrow a double-digit poll gap in the last weeks and score almost as well as Merkel's conservatives in the Sept. 18 election. Unable to form a government with her preferred partners, Merkel was forced into talks with the SPD.
The agreement between the longtime rival parties yielded compromises on both sides and that showed in a sober business-like news conference with Merkel and other party leaders.
"Coalitions are marriages of convenience. One shouldn't make too much of it," said outgoing SPD chief Franz Muentefering, who is to become labour minister and vice chancellor under Merkel.
"But I am optimistic," he said. "The personal relationships which are not unimportant in coalitions like this are solid and I think we can make politics together."
The CDU was unable to convince the SPD to reverse Schroeder's policy of phasing out nuclear power stations.
But they did win concessions from the SPD in labour market policy. Part of the VAT hike will go towards cutting non-wage labour costs -- a measure the conservatives say is crucial for encouraging German firms to hire.
Both parties must hope the measures do not hit the German economy, which is already showing one of the weakest growth rates in the 25-nation European Union.
"It looks like consumers are going to be hit hardest by these moves," said Rainer Guntermann, of the bank Dresdner Kleinwort Wasserstein. "The election promises we heard about sparing private households have not really been fulfilled."
A survey on Friday for ZDF television showed 63 percent of Germans were against the VAT hike.
However, given the dire state of German public finances, some commentators have welcomed signs of a concerted attack on the deficit.
In foreign policy, the parties have vowed to improve relations with the United States which were strained by Schroeder's staunch opposition to the Washington-led war in Iraq. The CDU and CSU, which oppose Turkey joining the EU, have agreed not to try to prevent membership negotiations that started in October from continuing. But they have vowed to ensure EU criteria imposed on Ankara are strictly adhered to.