The late-night agreement paves the way for a new center-right government to take office next week, nearly a month after Merkel's conservatives and the Free Democrats won a parliamentary majority in the September 27 federal election.

Just hours after reaching consensus, the coalition partners announced plans to cut taxes from January 1 next year.

"The burden on families has to be lessened, the burden on companies and inheritance tax has to be reformed," Chancellor Merkel said during a press conference in Berlin on Saturday.

"We are aiming for growth," she said, adding that the new government would focus on education and social cohesion. "We have agreed a coalition program showing that we want to advance courageously into the future."

At the joint news conference with Merkel, Guido Westerwelle, the leader of the Free Democrats, described the coalition agreement as "a great compass for our country."

Sharing key cabinet posts

The parties divided up key cabinet posts, with current Interior Minister Wolfgang Schaeuble of the CDU being chosen to head the finance ministry, while the FDP's Westerwelle is to become foreign minister.

The 67-year-old Schaeuble, who has been bound to a wheelchair since an assassination attempt in 1990 and has the reputation of being a hardliner on domestic security policy, was a surprise choice for the post of finance minister.

Ahead of the September election, he indirectly criticized Merkel's pledge to pursue billions of euros in tax cuts, saying there was little room for them given Germany's strained finances.

Now Schaeuble will be charged with implementing those cuts against the backdrop of a deficit that is poised to rise to double European Union limits next year.

News of his likely appointment sparked mixed reactions in Germany on Friday.

“He's an unknown entity when it comes to financial issues," Dennis Snower, head of the Kiel-based Institute for Economic Research, told the Reuters news agency. "You can't make any predictions about his future financial policy based on what he's done so far."

"I think he's a tough cookie and this is what will be needed," Carsten Brzeski, senior economist at ING Financial Markets said. "He is someone who would not be afraid of ruining his public image due to unpopular decision-making."

Thomas de Maiziere, Merkel's trusted lieutenant as chief of staff, is set to take over Schaeble's job at the interior ministry.

Free Democrats bag prominent posts

As widely expected, the post of foreign minister goes to FDP leader Guido Westerwelle. The 47-year-old is the first openly gay leader of a mainstream political party in Germany. He has no foreign policy or government experience.

Rainer Bruederle, the FDP's economics spokesman in the parliament for a decade, is set to replace Karl-Theodor zu Guttenberg as economy minister.

The media-savvy Guttenberg is set to head the defense ministry. The 37-year-old, who is a member of the CSU party, will be in charge of tackling the Afghanistan mission which is deeply unpopular in Germany.

The Free Democrats' Phillip Roesler is a surprise pick for the post of health minister. The 36-year-old, a rising star in the FDP, is currently the economy minister in the state of Lower Saxony and is reported to have led coalition negotiations on healthcare.

Born in Vietnam, Roesler will Germany's first Asian-born cabinet minister, also replacing Guttenberg as the youngest member of the cabinet.

Compromise on tax cuts

The deal over the new government came after the conservative bloc and the Free Democrats managed to reconcile their promise of billions of euros in tax cuts with a separate pledge to get Germany's deficit – swollen by massive stimulus packages – back under control.

Horst Seehofer, head of the Christian Social Union, the CDU's Bavarian sister party, admitted the final round of negotiations had been bogged down by financial issues.

"The financial issues at the end are always the most difficult and most exciting and you have to do that with great care," he said, explaining why the talks stretched into the night. "But it all worked out in the end."

To spur growth, the alliance plans to cut income taxes by 24 billion euros ($24 billion) between 2011 and 2013, according to Seehofer. That is more than the 20 billion euros Merkel wanted but far less than 35 billion euros the FDP sought.

"That number is right – even if you didn't hear it from me first," Seehofer said.

"I'm very pleased with this result," he added, referring to the coalition agreement after the protracted talks. "We've come up with a reasonable plan for the next four years and the coalition has set up a good platform for economic recovery in Germany."

rb/AFP/Reuters

Editor: Kyle James