Nov. 10 (Bloomberg) -- German Chancellor-designate Angela Merkel and Social Democrat leaders began the final phase of their talks on forming a coalition government, tackling sticking points that include how much to increase taxes to narrow the budget deficit.

Social Democrat General Secretary Klaus Uwe Benneter said Nov. 7 the coalition accord may include raising value-added tax to as much as 20 percent, as well as an increase in income tax for top earners, reversing one of Merkel's main pledges in the Sept. 18 election. Other topics still under discussion at today's talks in Berlin include the financing of measures to cut labor costs and the phasing-out of the country's nuclear power plants.

Christian Democrat Merkel, 51, is seeking to wrap up the negotiations with the Social Democrats on creating Germany's first ``grand coalition'' government since 1969 by Nov. 12. That would allow the lower house of parliament to vote Merkel into office as Germany's first woman head of government on Nov. 22, to replace outgoing Social Democrat Chancellor Gerhard Schroeder.

``The new government should see the new legislative period as a chance to press ahead bravely with the quite far-reaching reforms carried out by the current government in the labor market, social-welfare system and tax system,'' Bert Ruerup, the chairman of the government's council of five economic advisers, told a news conference in Berlin yesterday.

EU Limit

The two parties have made their top priorities boosting economic growth so as to increase employment, which is close to a post-World War II record, and to cut spending by as much as 35 billion euros ($41.2 billion) to reduce a budget deficit that exceeded the European Union's limit of 3 percent of gross domestic product in the past three years and is again forecast to do so in 2005.

The Social Democrats are pushing for an increase in the top rate of income tax to 45 percent from 42 percent for couples earning a minimum 500,000 euros a year, or single people earning 250,000 euros. That would also affect Germany's 2.8 million private companies, which pay income rather than company tax.

Merkel's election program foresaw a 3 percentage-point cut in the top tax rate to 39 percent and a reduction in the bottom rate to 12 percent from 15 percent, with the aim of boosting both consumer spending and company investment.

The CDU originally proposed a VAT increase of 2 points from the start of next year to lower non-wage labor costs. The Social Democrats opposed the idea in the election campaign, saying it would stifle consumer demand.

Sales Tax

Talks between the two parties are now centering on a possible 3-point rise in the sales tax, with the increase not taking effect until 2007, Joachim Poss, the SPD's finance spokesman in parliament, told today's Financial Times Deutschland newspaper.

``That would at least hurt the economy less than a first step in 2006,'' the FTD cited Poss as saying. ``We hope that the economic upturn will have strengthened by 2007.''

There is agreement that spending cuts at the Federal Labor Agency, which pays out jobless benefits and helps the unemployed to find work, should pay for a 1-point reduction in unemployment insurance contributions, Ronald Pofalla, a deputy parliamentary leader of the CDU, said yesterday.

The SPD will probably back the CDU's offer to spend the proceeds from a third of a 3-point sales tax increase on a reduction in insurance contributions by an additional percentage point, he said.

Growth Forecast

The panel of economic advisers said yesterday Europe's largest economy will expand just 1 percent in 2006 after growing only 0.8 percent this year. The forecast is more pessimistic than either the government or Germany's six leading economic institutes, which last month predicted growth of 1.2 percent in 2006.

The advisers said they opposed any move to raise VAT to reduce the budget deficit, which Merkel's future government is aiming to bring under the EU limit for the first time in six years in 2007. The panel instead called for cuts in subsidies, such as those to homebuyers, and the dismantling of tax exemptions.

Cutting subsidies by 6 billion euros would bring the deficit next year from a forecast 3.3 percent of GDP to below the EU limit without increasing VAT, the advisers said.

Juergen Thumann, head of Germany's BDI industry federation, said today he also opposes a VAT increase unless all the additional revenue is used to lower labor costs to make companies more competitive.

``A grand coalition only has limited possibilities to implement true reform measures,'' Thumann said in an interview in Berlin. Whether the coalition agreement ``will be the great escape trick that brings about the economic upturn I'm hoping for remains to be seen.''

To contact the reporter on this story: Claudia Rach in Berlin at crach1@bloomberg.net.

Last Updated: November 10, 2005 12:53 EST