BERLIN - Chancellor Angela Merkel's conservatives vowed Monday to seal a coalition deal, including tax cuts, with the pro-business Free Democrats (FDP) within a month after winning Germany's election.
Merkel's conservatives won a parliamentary majority on Sunday with the FDP, her partner of choice, enabling her to end her awkward four-year-old partnership with the Social Democrats.
Now the center-right parties must try to hammer out agreements on a range of issues including tax, labor market policy and the role of nuclear energy in Europe's biggest economy.
Coalition talks should start as soon as possible, said Ronald Pofalla, General Secretary of Merkel's Christian Democrats (CDU). It is our goal to have a coalition deal in a month at the latest.
The next government faces major economic challenges. It will have to curb a surging budget deficit, cope with rising unemployment and ward off a credit crunch.
Economists welcomed the result and Germany's bluechip DAX stock market index was up 0.9 percent by 1058 GMT on hopes the new coalition would adopt more pro-market policies.
The victory of the conservative-liberal bloc is a positive surprise for stock markets, but investors should not expect wonders due to the economic circumstances, said Roger Peeters, analyst at Close Brothers Seydler Bank.
Shares in nuclear plant operators E.ON and RWE were up by 3.4 and 2.75 percent respectively, driven by hopes the government will reverse a law to close atomic plants by 2020.
MERKEL TOUGH TALKS
The coalition negotiations could be tough because an emboldened FDP, buoyed by a strong showing in Sunday's vote, is likely to make hefty demands of the conservatives and it is unclear whether Merkel will adopt a more radical approach.
The FDP is likely to get three or four ministries. Traditionally it has controlled the foreign, economy and justice portfolios.
We would expect both parties to agree on a cautious reform approach with respect to the labor market and the social security system, said Goldman Sachs economist Dirk Schumacher in a research note.
The FDP will certainly push .. for more reforms but Merkel's reform appetite seems limited, he added.
While governing with the SPD in the last four years, Merkel has shifted leftwards and it is unclear whether she will stick to that in a partnership with the FDP.
Pofalla said his conservatives were committed to their election promise of tax cuts worth 15 billion euros ($22.03 billion) but the party has steadfastly refused to put a timetable on its plans, due mainly to weak public finances.
The FDP has more ambitious ideas, having waged its campaign on quick tax cuts worth 35 billion euros, and senior party members signaled a determination to push through those plans.
The voters expect (tax cuts) of us, we cannot chicken out, Hermann Otto Solms, the FDP's finance spokesman, told Der Spiegel magazine.
He said his party's plans were affordable. If necessary, spending cuts would be needed to consolidate the budget deficit, forecast to rise to 6 percent of gross domestic product in 2010.
Other priorities for the FDP are making it easier for firms to hire and fire, and shedding state holdings in firms like rail operator Deutsche Bahn.
Preliminary official results put Merkel's conservative bloc, the CDU and Bavarian Christian Social Union (CSU), on 33.8 percent, their second-worst postwar result, down from 35.2 percent in 2005.
The FDP offset the losses, surging to 14.6 percent, its best ever score, and putting the center-right ahead.
The SPD was the biggest loser and will join the Greens and Left party in opposition after plummeting more than 11 points to 23.0 percent, its worst result since World War Two.
(Addditional reporting by Michael Shields in Frankfurt)
(Writing by Noah Barkin and Madeline Chambers; editing by Mark Trevelyan)