BERLIN - GERMAN Chancellor Angela Merkel has bowed to pressure from her Bavarian allies and agreed to include tax relief in a new stimulus package designed to shield the economy from its worst recession since World War Two.

Just last month, Ms Merkel ruled out cutting taxes before the next federal election in September, but at a Sunday meeting with leaders of the Christian Social Union (CSU), she gave in to their demands for an easing of the tax burden.

Ms Merkel was meeting with her conservative CSU allies to agree a common position on a second German stimulus package ahead of a crucial Monday meeting with the other party in her uneasy 'grand coalition', the centre-left Social Democrats (SPD).

'We have agreed on a common concept for the negotiations with the SPD,' Mr Ronald Pofalla, the general secretary of Merkel's Christian Democrats (CDU) said after a late night meeting in the Berlin Chancellery which lasted nearly six hours.

'We have agreed to cuts in (health insurance) fees and to tax cuts in equal measure,' he added.

Ms Merkel's government was one of the first in Europe to agree measures to protect the economy in response to a crippling global financial crisis. But an initial package, agreed in November, includes only 12 billion euros (S$24.17 billion) in new spending and was widely criticised as too modest.

Europe's largest economy officially entered recession in the third quarter of last year and leading economic institutes have forecast that it will contract by 2 per cent or more this year - easily the worst annual performance in the post-war era.

Under pressure from her own party and European partners abroad, Ms Merkel acknowledged in recent weeks that there was a need for a new package, but deep divisions soon emerged within her government over what it should include.

Partisan sniping
The SPD, forced into a ruling partnership with Merkel's conservatives after a tight 2005 election, have staunchly opposed tax cuts.

But the ruling parties are in agreement that new government spending in a second package should go towards infrastructure projects and schools.

The SPD also supports cuts in health insurance fees that are subtracted from the paychecks of German workers, suggesting a compromise may be possible at the coalition meeting on Monday.

Partisan sniping within Berlin's coalition has risen in the run-up to a politically charged year packed with 5 regional elections and the September federal vote.

Despite repeated reversals in her response to the global financial crisis, Ms Merkel remains popular and polls suggest she is on track to win re-election. But she must ensure Germany's economic woes do not lead to a decline in support.

The plans agreed by her conservatives on Sunday envision raising the annual salary threshold for which no income taxes must be paid to 8,000 euros from 7,664.

They also include steps to eliminate so-called 'cold progression', a process in which taxpayers are bumped up into higher tax brackets even when their real incomes have not grown.

This occurs in Germany because tax brackets are not adjusted automatically for inflation. -- THOMSON REUTERS