Sept. 28 (Bloomberg) -- German Chancellor Angela Merkel said she’ll press ahead with tax cuts and labor-market deregulation after winning re-election with enough support to govern with the pro-business Free Democrats.

With Germany struggling to recover from the deepest economic slump since World War II, voters spurned plans by Merkel’s Social Democratic challenger to raise taxes on top earners. Frank-Walter Steinmeier’s SPD had its worst postwar result in what he called a “bitter day” after sharing power with Merkel for four years and governing for the previous seven.

“There’s a clear sentiment in favor of economic changes, especially on income taxes,” Tilman Mayer, head of the Bonn- based Institute for Political Science, said in an interview. “Voters have turned their back on grand coalition-style compromise politics.”

Merkel, 55, said on ARD television that talks on forming a coalition with the Free Democrats will proceed quickly, and her focus will be on creating jobs in Europe’s biggest economy. She dismissed the FDP’s call for a complete overhaul of the tax system, saying she wanted to be seen as the “chancellor of all Germans” and won’t let her new junior partner dictate policy.

During the campaign, she pledged to pursue deregulation, extend the life of nuclear-power plants and introduce across- the-board tax cuts of 15 billion euros ($22 billion).

Reform ‘Mandate’

The result of yesterday’s election will “modestly enhance the long-run growth potential of the country,” Holger Schmieding, chief European economist at Bank of America-Merrill Lynch in London, said in a phone interview. “The government has a mandate, not for dramatic change, not for a Thatcherite revolution, but it is a mandate for some supply-side reforms.”

The euro may advance and bunds fall on the election result. The currency has climbed 5 percent against the dollar this year on speculation the euro region may be emerging from recession. Uto Baader, chief executive officer of Baader Bank AG, based in Unterschleissheim, said before the election that “the market will jump” with a Merkel-FDP government.

President Barack Obama called to congratulate Merkel on her re-election, the White House said in a statement. He and Merkel agreed that their cooperation will further strengthen with the election of “a strong German government.”

Declining Support

Merkel’s Christian Democrats and their Bavarian sister party, the Christian Social Union, won 33.8 percent in the elections to the 622-seat lower house of parliament and the Free Democrats 14.6 percent, according to provisional complete results. The Social Democrats had 23 percent, a drop of 11.2 percentage points from 2005, the biggest decline for any party in postwar history. The anti-capitalist Left Party won 11.9 percent and the Greens 10.7 percent.

Voter turnout was 72.5 percent, a record low.

While CDU-FDP won a 42-seat majority, Merkel also steered her party to its worst result in modern Germany’s 60-year history. Merkel and Steinmeier’s two blocs saw their support plummet to 57 percent, compared with a combined 69 percent in 2005 and 77 percent in 2002.

Guido Westerwelle’s FDP recorded its best-ever result, putting it in position to push its agenda.

Merkel pledged to cut the lowest tax rate to 12 percent from 14 percent and raise the threshold for the top rate to 60,000 euros from 52,000 euros. The Free Democrats want to replace the progressive income-tax system and its exemptions with just three brackets: 10 percent, 25 percent and 35 percent.

‘Bumpy Ride’

“Merkel can’t expect her coalition partner to slot into its historic role as the junior mascot,” Hans-Juergen Hoffmann, managing director of Berlin-based polling company Psephos, said in an interview. “The FDP made brash promises to voters to push economic growth, above all to cut taxes, and knows it will be measured by its resolve to see them through. Merkel could be in for a bumpy ride.”

Germany, the world’s biggest exporter, was worse hit than other Group of Seven economies as the global recession hurt foreign sales of Munich-based Siemens AG machinery and Wolfsburg-based Volkswagen AG cars. Gross domestic product unexpectedly grew by 0.3 percent in the second quarter, ending Germany’s recession.

Net new borrowing is forecast to almost double next year to 86.1 billion euros from a record 47.6 billion euros this year, the government budget shows, prompting Finance Minister Peer Steinbrueck, a deputy leader of the Social Democrats, to reject tax cuts as “smoke and mirrors.” The Free Democrats may now control the Finance Ministry after the Social Democrats’ defeat.

Confident on Taxes

“I feel very confident that a tax reform will be coming,” Fred Irwin, president of the American Chamber of Commerce in Germany, said in an interview. “With lower taxes and less bureaucracy, the economy will go up.”

Westerwelle, 47, who may replace Steinmeier as vice chancellor and foreign minister, said on ARD that the Free Democrats “now expect to deliver, step by step, on what we promised voters.”

Foreign policy is not expected to change significantly, analysts say. Westerwelle, an attorney, supports strong trans- Atlantic relations and advocates nuclear disarmament. He backs NATO’s military engagement in Afghanistan, where Germany has 4,200 troops. The FDP wants to abolish the draft and shift to an all-professional military.

Merkel and Westerwelle favor extending the lifespan of nuclear plants by as many as 15 years, overturning a law negotiated during former Chancellor Gerhard Schroeder’s SPD-led government with the Greens that will shut them by about 2021.

At stake are stations run by Dusseldorf-based E.ON AG, Karlsruhe-based EnBW Energie Baden-Wuerttemberg AG, RWE AG of Essen and Sweden’s Vattenfall AB that generated 23 percent of Germany’s electricity last year. Polls consistently show Germans opposed to an extension of nuclear power.

“The new coalition will almost certainly now seek to extend the life-cycle of the younger atomic plants,” said Claudia Kemfert, an analyst at the Berlin-based DIW economic institute. “The nuclear bogey plainly didn’t help the SPD, for it played no role in this election.”

To contact the reporters on this story: Tony Czuczka in Berlin at aczuczka@bloomberg.net; Brian Parkin in Berlin at bparkin@bloomberg.net

Last Updated: September 28, 2009 02:03 EDT