The court in Karlsruhe ruled capping the Pendlerpauschale tax credit granted to people who travel between their homes and workplace in early 2007 violated the country's Basic Law.
The decision will force the government to revert to the former tax regime starting in January and to reimburse the money taken in last year totalling some €3.0 billion. The Finance Minstry said the decision would leave the public finances short by €7.5 billion from 2007 through 2009.
Finance Minister Peer Steinbrück disagreed with the court's decision but added that "the reimbursement should be made as quickly as possible ... to give consumption an added push." He said some 20 million people who paid too much in taxes should get a refund by the end of March.
The refund comes amid a debate over how to reigite Europe's biggest economy, which has fallen into recession.
"I consider it absolutely essential that we reimburse the money directly to the people, given the current economic situation," Chancellor Angela Merkel said in Warsaw on Tuesday.
The German automobile manufacturers association VDA and trade unions also quickly hailed the court ruling.
According to the Finance Ministry, a full-time worker who lives at least 20 kilometers from their workplace should receive an average payment of €350 early next year. But the decision "should not please those who had hoped for an overall reduction in tax rates, because we will not be able to do both," warned Steffan Kampeter, public finance expert for the conservative CDU/CSU parliamentary group.
Green groups criticised the ruling, because the tax break "leads to more automobile traffic and a scattering of habitations" that harm the environment, said Michael Gehrmann, head of the environmentally-oriented car owners' association VCD.