The opposition parties – who currently control the majority of the 16 Länder governments which are represented in the Bundesrat – voted on Friday to block tax cuts proposed by Chancellor Angela Merkel's centre-right coalition government.
The proposals would have raised the limit for tax-free earnings by €350 in two stages, to reach €8,354 by January 2014.
The measure was intended to help employees offset the impact of inflation on their purchasing power by tackling so-called cold progression, where tax brackets do not keep up with inflation.
When earnings rise to keep up with inflation, they push people into higher tax brackets that have not changed, leaving them paying more tax on what is in real terms unchanged earnings.
The bill failed to win a majority in the upper house, where Social Democrats and Greens voted down the measure that the lower house of parliament, the Bundestag had passed in March. Opposition politicians said there was not enough in the public purse to operate with €6 billion less in future.
Chancellor Angela Merkel's Christian Democrats and their partners in government, the pro-business Free Democrats will now hand the draft law over to a mediation committee in a last attempt to push through the break for taxpayers in Europe's biggest economy.
The government will continue to fight against "secret tax hikes" resulting from cold progression, government spokesman Steffen Seibert told the Die Welt newspaper after the vote on Friday.
The political signal from the opposition is unmistakable – it comes just two days ahead of Sunday's state election in North Rhine-Westphalia, Germany's most populous state, according to a report in Der Spiegel .
Opposition parties are piling pressure onto Merkel's coalition in a bid to underline widespread dissatisfaction with the government a year ahead of federal elections.