Mr Schroeder's proposals have been watered down

A compromise deal was reached after more than nine hours of talks and brings to an end months of wrangling.

Taxes will drop by 7.8bn euros (�5.5bn; $9.5bn) next year, half the amount initially tabled by Mr Schroeder.

Opposition parties had blocked the earlier plans, claiming they would lead to unacceptable levels of state debt.

'On the move'

Mr Schroeder has staked his political future on a set of reforms - known as Agenda 2010 - which also aim to change labour and welfare laws.

Commenting on the agreement, Mr Schroeder said: "It will stabilise the recovery in the domestic economy.

"It also shows that Germany is able to reform itself and is in a position and ready to retake its role as an economic leader.

"Germany is on the move."

Analysts were more circumspect, welcoming the breakthrough, though adding it was only a first step.

Opposition

Without further reform, Germany's economy may struggle to shake off its "sick man of Europe" tag, they said.

Can the reforms lift Germany's economy?

Economy and Labour Minister Wolfgang Clement forecast that the tax cuts "should add up to 0.6 percentage points in additional growth" next year.

Last month, the Bundesrat, where Germany's 16 states are represented, blocked Mr Schroeder's original plans.

The chamber is dominated by the opposition Christian Democratic Union and its Bavarian sister party, the CSU.

CSU leader Edmund Stoiber, who was narrowly defeated by Mr Schroeder in national elections, was accused of stalling the process simply to make a political point.

Budget deficit

Some of Mr Schroeder's own party, meanwhile, accused him of selling out and attacking the rights of workers.

However, opposition politicians said they were satisfied with the watered down tax cuts.

They had voiced concerns that the reforms proposed initially would have strained public finances and forced the government to run up too much new debt.

Germany's budget deficit already exceeds the 3% of gross domestic product limit set out by eurozone rules.

To help pay for the tax cuts and keep the deficit in check, the government will sell its stakes in companies such as Deutsche Telekom and Deutsche Post.

It also will lower some subsidies for companies.

Too optimistic?

Mr Schroeder hopes that the tax cuts, which are at the heart of his reforms and have helped drive expansion in the US, will lift the economy.

The government is forecasting economic growth of as much as 2% next year, but many analysts warn that may be too optimistic.

A report last week showed that German exports fell in October as the euro's rise against the dollar made non-EU exports less competitive.

Unemployment, meanwhile, is proving difficult to reduce, with the national rate still more than 10%.