The German stock market soared yesterday after the country's upper house of parliament overwhelmingly approved a sweeping reform of the tax system that is expected to boost the economy of the euro zone as a whole.

Chancellor Gerhard Schroder hailed the Bundesrat's decision as a significant breakthrough that will reinforce Germany's recovery and cut unemployment.

"No one is talking any more about the German disease, that logjam in the reform process. They are saying things are really moving in Germany," he said.

The vote was an important victory for the Chancellor, whose centre-left government does not command a majority in the 69-seat Bundesrat, where Germany's 16 federal states vote as separate blocs.

The government agreed to cut the top rate of income tax by an extra 1 per cent and to introduce DM2 billion worth of tax breaks for small businesses to persuade five states where the Chancellor's Social Democrats govern with opposition parties to support the reform bill.

The Frankfurt DAX leapt by 2 per cent when the decision was announced and economists predicted that the reforms will boost German growth, estimated at 3 per cent this year, by a further half a per cent in 2001.

But the opposition Christian Democrats, for whom the vote represents a serious setback, accused the Chancellor of bribing and bullying impoverished federal states into approving the measures.

"I have not witnessed such an abuse of a constitutional body in my 30 years in politics. The Bundesrat has been bypassed shamelessly," said Thuringia's prime minister, Mr Bernhard Vogel.

The reform means that corporation tax will fall to 25 per cent from its present level of 40 per cent. The top rate of income tax will fall in stages to 42 per cent in 2005 from 51 per cent today and the bottom rate will drop to 15 per cent from 22.9 per cent.

The finance minister, Mr Hans Eichel, insisted that the last-minute package of sweeteners, which add DM7 billion to the DM50 billion cost of the tax reform, will not prevent him from balancing Germany's budget by 2006.

The key to Mr Schroder's success in pushing through the reform lay in the decision by Christian Democrats in three states where they share power with his Social Democrats to defy their party's leadership and back the government.

Mr Schroder is understood to have used a mixture of threats and promises in private talks with Christian Democrats in Bremen, Berlin and Brandenburg - all three of which are states with serious budget problems.

Berlin's governing Mayor, Mr Eberhard Diepgen, is believed to have decided to support the government after the Chancellor hinted the federal government might refuse to pay for major security operations in the city and would reconsider its funding of a dozen museums in the capital.

Berlin's government, which is utterly broke, needs federal support if it is to present itself as a showcase city in time for the World Cup championship to be held in Germany in 2006.

"I am responsible for Berlin and not for the whole of Germany. The Bundesrat is a federal organ, but a federal organ of states," Mr Diepgen said yesterday.

The government scored a second success yesterday when the Bundesrat approved its plan to introduce a Green Card immigration system to allow thousands of computer experts from outside the EU to move to Germany.

The next major reform on the chancellor's agenda is an overhaul of Germany's pension system to offset the impact of the country's ageing population.

He urged the opposition yesterday to learn from their defeat over tax reform by supporting his proposals on pensions.

"My advice, my request, to the opposition is, don't repeat with pension reform what you did here, it didn't work," he said.