The German government is putting the finishing touches this week on an austerity program that offers a chance of a fresh start, not just for the country's complex and bloated tax and welfare system, but also for Chancellor Angela Merkel.

Her ruling center-right coalition plans tax hikes, new taxes and radical savings in areas including defense to rein in the budget deficit starting in 2011, SPIEGEL ONLINE has learned. It aims to finalize its planned savings program at a meeting on Sunday that the government hopes will give it a boost after months of setbacks that have triggered a plunge in public support for it. 

According to sources in the coalition of conservatives and pro-business Free Democrats (FDP), the parties are discussing raising the tobacco tax and introducing new levies on nuclear fuel rods, airline ticket purchases and financial transactions. Media reports this week said Defense Minister Karl-Theodor zu Guttenberg is reviewing a possible reduction in the Bundeswehr German army by as many as 100,000 troops to 150,000 and suspending mandatory military service.

The spending cuts and tax hikes are part of Merkel's pledge to foster a new "culture of stability" in Europe  by helping to slash the continent's burden of public debt that has plunged the European single currency into crisis.

The Americans don't like the plans. The atmosphere was decidedly frosty at a meeting last week in Berlin between US Treasury Secretary Timothy Geithner and German Finance Minister Wolfgang Schäuble, because the two men fundamentally disagree. Geithner urged the Europeans to spend more and to run up debts to boost economic growth and help the global economy. Schäuble countered that high debts were the root of the turmoil now engulfing the euro zone.

Back to Reality

The meeting didn't just highlight a rift between Germany and the US on economic policy. It also marked a fundamental shift in thinking in Merkel's coalition. Ever since Merkel won re-election in September, her policies have seemed divorced from reality.

Her coalition pledged tax cuts and passed a "Growth Acceleration Law" that accelerated the pace of public borrowing. There was a cut in the inheritance tax, corporate taxes were lowered and the statutory health insurance system got a record injection of tax money. In addition, child benefits were increased. The government decided to put off all the difficult reform policies until after the important state election in North Rhine-Westphalia on May 9. That was a ploy to keep voters sweet, but it backfired.

Merkel's conservative Christian Democrats (CDU) suffered heavy losses in the state and the center-right coalition lost its majority in Germany's upper legislative chamber, the Bundesrat, which represents the interests the country's 16 states, as a result. A poll by the Forsa Institute released on Tuesday showed support for the Christian Democrats and their Bavarian sister party -- the Christian Social Union, which share power at the national level -- at just 30 percent, its lowest level in four years. The slide in support for the CDU and FDP has been greater than any ruling coalition has suffered since the end of World War II.

That is why next Sunday's coalition meeting in the town of Meseberg west of Berlin is so crucial for Merkel's beleaguered government. She needs to ditch a mentality that has prevailed in German administrations for the last 60 years -- to finance public spending programs with borrowed money. It's an approach that is placing a huge burden on coming generations.

Massive Debt Burden

Statistically, every person working in Germany shoulders €43,000 ($52,500) in public debt. Even if the debt mountain doesn't rise any further, that figure will soon reach €48,000 because the working population is shrinking as a percentage of the total population.

It can't go on like this. Germany has already committed itself to two sets of rules that are designed to force the nation to become more frugal. Firstly, the Stability Pact for Europe's monetary union will force the government to reduce the deficit from 5 percent of GDP now to below the 3 percent ceiling by 2013. Secondly, Merkel's previous government, a so-called grand coalition of conservatives and center-left Social Democrats, agreed on a "debt brake," a balanced budget and debt reduction program forcing the government to reduce its structural deficit -- the recurring gap between revenues and spending -- to €60 billion from the current €70 billion.

Now Merkel and Schäuble face the mammoth task of saving €10 billion per year from 2011 onwards to meet those requirements. They must also adapt the cradle-to-grave social welfare system so that it can cope with demographic changes -- namely a population that is expected to shrink considerably in the coming years. In the pension, nursing and health insurance systems, the government has no option but to scale back benefits and find new sources of income.

Germany is at a crossroads. For decades, the nation was accustomed to economic growth and rising benefits. Now Germany must save its way back to health.

The task facing Merkel's coalition is greater than in 2003 and 2004 when the center-left government under then-Chancellor Gerhard Schröder launched its "Agenda 2010," the country's most radical program of welfare cuts since World War II.

Concern Over Political Fallout

In public, the coalition politicians claim to be determined to make wide-ranging cuts. But behind the scenes they are deeply worried that the cutbacks could choke economic growth. How can they shield their own voters from the pain? And is it possible to win elections while imposing cuts?

Trade unions and business lobbies are getting ready to resist any savings that might hurt their interests.

It is clear, however, that after half a century of uninterrupted increases, the catalogue of public spending contains a wealth of dubious items. The state has built ports, bridges and canals that turned out to be unnecessary. It subsidizes industry sectors whose products no one wants and spends billions on defense technology that doesn't work. Instead of motivating the unemployed to find work, it creates incentives to stay at home.

Saving in these areas would in many cases not only be more efficient, but fairer too. Slashing unwarranted financial subsidies often leads to greater economic growth as well as reduced spending. Curtailing tax benefits helps create the simple and fair tax system that the FDP keeps demanding.

VAT Ís a Bureaucratic Monster

Take value-added tax. When it was introduced at the end of the 1960s it was still an easily understandable tax designed to secure stable tax revenues. There was a single rate on most goods, and only food and important consumer products were subject to a reduced rate. Forty years on, the tax has grown into a bureaucratic monster, a jungle that even perplexes tax experts.

The Finance Ministry's list of products exempt from the standard 19 percent rate amounts to 200 pages. Mules for example are taxed at a lower rate than donkeys, for some reason. And why is there a reduced VAT rate for truffles, goose and duck liver and meat products from beavers, whales, frogs and tortoises?

The previous government introduced a reduced VAT rate for ski lifts. The new center-right government recently cut the rate for hotels and camping sites in a move that will reduce tax revenue by €1 billion this year.

Existing government programs aren't having the desired effect. Germany spends more money on family policy than most other nations and gets precious little in return. Researchers at the University of Frankfurt calculated that Germany has 150 different benefits for families and children, distributed by 40 separate authorities, which amount to €150 billion per year. There is no evidence that this money has achieved a significant reduction in the number of children living in poverty, or an improvement in their education prospects.

According to the government's annual report on poverty, the number of children judged to be dependent on state benefits is rising steadily. State benefits designed to encourage people to have children aren't having much effect in increasing the birth rate, either. The average number of births per woman has stagnated at the low level 1.38.

A radical overhaul of state spending is also needed in other areas of government, for example in transport policy. Whenever it comes to trains, planes and automobiles, politicians are in their element. Sometimes the subsidy is intended to improve public transport, sometimes to help the environment or boost competitiveness. The fact that these goals sometimes contradict each other rarely deters politicians.

Rampant Subsidies

The tax on gasoline is around 65 cents a liter while diesel tax is 47 cents. But that doesn't apply to farmers -- they only pay around 26 cents in tax for their liter of diesel. The tax breaks for diesel fuel cost the state more than €6.4 billion in lost revenue each year. It's one of many examples of rampant subsidization involving fuel. Aviation fuel has been exempt from tax for more than 30 years to protect German airlines. So is diesel for ship's engines.

Michael Thöne, the head of the Cologne Center for Public Economics, and Clemens Fuest, an economics professor at Oxford University who is an advisor to the German Finance Ministry, have proposed a way to save significant sums of public money in the medium term. It involves the state examining the standard of public service it achieves for the money it spends and comparing the results with those of other nations. Sweden and Japan, for example, have scored better than Germany in the OECD's "Pisa" surveys of international education standards, yet they spend less on education.