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German Chancellor Angela Merkel reined in Free Democratic Party leader Guido Westerwelle’s expectations of rapid tax cuts as they began negotiations to form Germany’s next government.

Merkel, in an interview last night on ARD television after inviting Westerwelle for talks at the Chancellery in Berlin, said Germany’s soaring budget deficit limits the scope for tax relief. She reiterated there won’t be any tax cuts before 2011, a stance at odds with Westerwelle’s vow to push for more tax relief sooner.

Merkel said yesterday she aims to forge a coalition agreement by Nov. 9, when Germany will mark 20 years since the fall of the Berlin Wall. Differences over taxes, labor- market deregulation and foreign policy aspects need to be bridged if the parties are to form a government within the six-week period.

“You won’t see a lot of bickering on the surface,” Gary Smith, director of the American Academy in Berlin, a trans-Atlantic research institute, said in an interview. “But it’ll be there.”

Merkel, 55, and Westerwelle, 47, held their first coalition talks in Berlin yesterday, the day after Merkel’s Christian Democrats won re-election with the lowest score since World War II. The Free Democrats recorded their best result in the 60-year history of modern Germany.

Tackling the deficit and setting spending for 2010 will be a top priority of the new administration, Merkel said.

Budget ‘Leeway’

“I expect we’ll agree very quickly on tax policy, especially when you look at the leeway we have with the budget,” she said.

Germany’s deteriorating finances overshadow the coalition-building. Merkel’s administration will borrow a record 329 billion euros ($482 billion) in 2010 as it boosts spending to speed economic recovery.

The borrowing forecast, made in June by Social Democratic Finance Minister Peer Steinbrueck, takes no account of 35 billion euros in tax cuts sought by the FDP. Merkel’s tax pledge amounts to 15 billion euros over her four-year term. Merkel told reporters that “naturally we’re not going to depart from” the CDU program.

‘Middle-Class Belly’

“For us the most important thing is to cut taxes in the area of what we call the middle-class belly,” Otto Fricke, the Free Democratic head of the budget committee in the outgoing parliament, said yesterday in an interview. “It’s the average Joe” who suffers most under the current tax system. Merkel “has to find solutions.”

Merkel will also need to try to merge the platform of her bloc, which includes the Bavarian Christian Social Union, with demands by the FDP for a simpler income-tax system comprising just three brackets: 10 percent, 25 percent and 35 percent.

“Merkel should be under no illusions: this alliance will only happen thanks to the FDP’s strong showing,” Tilman Mayer, head of Bonn-based Institute for Political Science, said in an interview. “Westerwelle will make his voice heard in coalition talks and demand a good deal of what the FDP’s been pushing for in the campaign.”

Westerwelle told reporters yesterday that he’ll push “with full determination” for as much of his program as possible to be accepted. “It’s clear that our compass in these negotiations is our party program,” he said.

Afghan Mission

Afghanistan, where Germany has about 4,200 troops as part of NATO forces, is another point of potential friction. Westerwelle, the probable foreign minister replacing Frank- Walter Steinmeier, has accused Merkel’s former government with the Social Democrats of providing too few trainers for Afghan security forces.

Westerwelle wants to end the mission “as quickly as possible,” Der Spiegel magazine cited him as saying in an interview last month. That’s a more urgent tone than Merkel, who said Sept. 8 that Afghan forces must make “enough progress in the next five years to allow international troops to steadily reduce their role.”

Prospects for German defense suppliers such as Duesseldorf-based Rheinmetall AG “could be seen negatively” because “a strong FDP within the government may mean earlier-than-expected withdrawal of troops from Afghanistan,” UBS Investment Research analyst Sven Weier said in a note yesterday.

Firing Rules

The FDP’s campaign call to give German business more leeway to fire workers also goes further than Merkel’s party. Firing rules currently apply for companies with more than 10 employees and the FDP wants to raise the threshold to more than 20 employees.

“That’s a highly contentious, highly emotive subject,” Holger Schmieding, chief European economist at Bank of America- Merrill Lynch in London, said in an interview. Merkel and the FDP will probably look for other ways to change labor laws, he said.

Hans-Juergen Hoffmann, managing director of Berlin- based polling company Psephos, said Merkel “can’t expect her coalition partner to slot into its historic role as the junior mascot.” Westerwelle’s party “will have none of that,” he said in an interview. “It’s the kingmaker of Merkel’s new coalition.”

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