The leaders of the three coalition partners – including FDP leader Philipp Rösler and Horst Seehofer, head of the conservative CSU – found compromises on five key areas that have caused conflict in the government.
Apart from the tax cuts demanded by the pro-business FDP, state insurance payments for dementia patients will be increased, and a child care subsidy for keeping children under three at home will be introduced.
On top of that, red tape will be reduced for skilled immigrants, and there will be an additional billion euros investment in infrastructure.
The chancellor said the aim of the package was to relieve the tax burden on small and medium incomes by €6 billion in two stages – on January 1, 2013 and January 1, 2014. The measures would include lifting the lower threshold for a tax-free income.
The plan broadly follows an agreement reached between Finance Minister Wolfgang Schäuble and Economics Minister Philipp Rösler in October to address so-called "bracket creep" in the tax system, where inflation pushes people into higher tax brackets.
The CSU, which has resisted all tax cuts so far, apparently agreed to the €6-billion tax relief plan in part because the federal government is to give up €4 billion in tax income, while the states and municipalities will lose €2 billion.
This makes it much more likely to pass through the upper house of the German parliament, the Bundesrat, which is made up of the representatives from Germany’s 16 state governments.
Seehofer also likely agreed to the plan because of the introduction of the CSU’s favoured child care subsidy called Betreuungsgeld. The FDP and large parts of CDU previously opposed the subsidy, calling it counter-productive to the government's attempt to increase day care for small children.
On the issue of skilled immigrants, the new deal means that skilled workers only need to prove they can earn an income of €48,000 a year, rather than €68,000, and includes the introduction of a "blue card," a version of the "green card" granted in the United States.
The agreement – which many commentators doubted would ever come to pass – puts pressure on the opposition parties who control the Bundesrat.
Green party leader Jürgen Trittin told the Rheinische Post newspaper on Monday called the agreement "a poisoned chalice, that future generations will get to drink from."
Most of the changes will only come into effect in 2013, just in time for the general election in the autumn of that year.
Merkel said the tax cuts came under the heading “Strengthening growth in Germany,” and would make the system fairer, though she emphasized that consolidating the state budget would remain a priority, and Germany’s constitutionally-agreed debt ceiling would not be broken.
“We also want to thank all the citizens for making so many sacrifices in the international financial and economic crisis,” she added after the coalition talks.