* New government pins budget hopes on economic rebound
* Debt brake law limits Merkel's fiscal flexibility
* New minister ready to take flak for unpopular savings
By Noah Barkin
BERLIN, Oct 25 (Reuters) - Chancellor Angela Merkel's new centre-right government has put off tough decisions on tackling the bulging deficit in a high-stakes bet the German economy will rebound sharply and reduce the need for unpopular savings.
But with a surging euro clouding Germany's export prospects, unemployment set to rise and fragile banks restricting loans to companies and consumers, the economic outlook remains shaky and the likelihood high that Merkel will be forced to slash spending by the end of next year.
Her fiscal challenge is all the more daunting because of debt-brake legislation introduced by her outgoing "grand coalition".
The new rules amount to a financial straitjacket for her incoming government of conservatives and Free Democrats (FDP), obliging it to sharply reduce borrowing from 2011 regardless of how Europe's largest economy is performing.
In his first interview since being named Merkel's new finance minister at the weekend, Wolfgang Schaeuble defended the government's "wait-and-see" approach to the budget but signalled savings were only a matter of time.
"Where we save, we will see step by step, depending on how the economy develops," he told the German daily Die Welt. "No one can say when the time will be right: we are taking a wait-and-see approach, we should be honest about that."
Merkel sealed a coalition agreement with the FDP on Saturday and in a news conference laid out plans to cut income taxes by 24 billion euros ($36.01 billion) from 2011.
New tax breaks for families with children and cuts in corporate and inheritance taxes, which will take effect from next year, promise to reduce government revenues even further.
Federal new borrowing, currently estimated to rise to a record 86 billion euros next year, may end up closer to 100 billion because of the plans. Even before the tax cuts, Germany's deficit was set to rise to 6 percent of GDP in 2010, double European Union limits.
"We need to blaze a path for growth, otherwise it will be impossible to generate the savings we need," Merkel told reporters on Saturday.
SHARP BREAK
The approach is a sharp break with the disciplined fiscal line taken by her outgoing coalition, which pushed through a big increase in value-added tax (VAT) shortly after taking power and resisted pressure from allies for more stimulus to fight the crisis -- all in the name of budget discipline.
Business groups praised the new tax plans over the weekend, saying they would help companies suffering from the after-effects of the crisis, notably "Mittelstand" small and medium-sized businesses which are the backbone of the economy.
But even with a strong pickup in growth -- the government expects gross domestic product (GDP) to rise 1.2 percent next year after tumbling 5.0 percent in 2009 -- economists are sceptical the government can get the maths to add up without reining in spending soon.
Andreas Rees, an economist at Unicredit, estimates that at most a third of the tax relief planned by Merkel's incoming government will be self-financing.
"If the coalition wants to reduce the debt mountain from 2011, then in addition to strong growth they will also need to make savings," he said. "These savings will probably need to be on a big scale."
They could come soon after a May election in the state of North Rhine-Westphalia (NRW), a make-or-break vote the prospect of which helped persuade Merkel to avoid savings pledges in the coalition pact.
Should her party ally Juergen Ruettgers lose power in the western region, Merkel would lose her centre-right majority in the Bundesrat upper house of parliament.
Opposition parties could then gang up to block government legislation, producing the same policy gridlock that haunted her predecessors Gerhard Schroeder and Helmut Kohl in their last years in office.
"As far as I can see the new government doesn't have any measures to get back to fiscal sustainability, but after NRW this will be back on the agenda," said Juergen Michels of Citigroup.
MAN FOR THE JOB
Schaeuble, a hard-nosed veteran of Merkel's CDU, is a deft pick to push through unpopular spending cuts.
In nearly four decades in politics, the former Kohl protege has earned a reputation for ramming home his views without regard to public opinion or the latest trends in Berlin.
He was one of the few German politicians publicly to back the U.S.-led invasion of Iraq back in 2003. As interior minister under Merkel he resolutely refused to allow prisoners from the U.S military prison in Guantanamo Bay into Germany despite huge pressure from Washington and his fellow cabinet members.
"Schaeuble is 67, this is his last job and he can be tough. He will be tough," wrote the Financial Times Deutschland in an editorial on Sunday. (Writing by Noah Barkin, editing by Tim Pearce)