The initiative aims to deprive the National Democratic Party of Germany (NPD) of taxpayers' money, to which German political parties are generally entitled, before September elections.
Handing government funds to the NPD amounted to "a direct state subsidy for far-right hate speech," said Justice Minister Heiko Maas.
Germany's highest court had in January rejected a bid by the parliament's upper house to ban the NPD, ruling that although it held a similar ideology to the Nazis, it was too small to endanger German democracy.
The NPD, with some 6,000 members, was founded in 1964 as a successor to the neo-fascist German Reich Party, rails against foreigners and campaigns with the slogan "Germany for the Germans".
Interior Minister Thomas de Maiziere said his ministry had prepared changes to the constitution and to other laws that would have to be adopted by parliament with two-thirds majorities in both chambers.
He said the idea that a party hostile to the democratic order receives official funding "is a situation that is hard to take".
German political parties receive state campaign finance funds if they have won at least 0.5 percent of the popular vote in the latest general or European elections, or one percent in a poll in one of Germany's 16 states.
The NPD garnered just above one percent in Germany's last elections in 2013, insufficient for it to win representation in parliament.
It has also lost ground to the right-wing populist and anti-immigration Alternative for Germany (AfD), which currently polls at between eight an 11 percent.