Germany's ambitious package of reforms aimed at kick-starting Europe's largest economy has hit a brick wall.
Chancellor Schroeder's plans are in jeopardy
The opposition-controlled upper house of parliament rejected plans to speed up 15.5bn euros ($18bn) of tax cuts. It also vetoed labour law changes.
Chancellor Gerhard Schroeder has staked his political future on the reforms - known as Agenda 2010.
A parliamentary committee will now try to find a compromise by Christmas.
Mr Schroeder hopes that tax cuts, which are at the heart of his reforms and have helped drive expansion in the US, will also crank up the stagnant German economy.
He warned of the consequences of failing to approve the reforms when the argument goes to the parliamentary arbitration committee.
"The conservatives will then be responsible for less growth
and more unemployment and will have to explain to the German
public why it is putting power political games before the
interest of the people," he cautioned.
But conservatives fear that the tax cut
will force the government to run up too much new debt and are calling for a fundamental rethink.
And Bavaria's premier and leader of the conservative Christian Social Union (CSU) denied that the vote was politically-motivated.
Schroeder must now negotiate with opposition parties
"We are not blocking these tax cuts out of party political or tactical grounds," said Mr Stoiber, who ran against Mr Schroeder in the last general elections.
"We want to make them possible, but with different financing. Not financing on credit."
The country's budget deficit already exceeds the European Union limit of 3% of gross domestic product.
The Bundesrat, where Germany's 16 states are represented, is dominated by the opposition Christian Democratic Union and their Bavarian sister party, the CSU. They have voiced concerns that the proposed reforms will strain public finances even further.
A government report Friday highlighted the ongoing troubles of the German economy.
German industrial production unexpectedly fell in September from the previous month. Output dropped 1.2 % from August.
While the government is forecasting economic growth of as much as 2% next year, many analysts warn that may be too optimistic.
"The reforms are very necessary," said Mike Bayer, who helps manage about 220m euros of stocks and bonds at Ceros in Frankfurt. "There will be negotiations and I expect the reforms to go through at the start of next year."
"Just not as they are now. They will be watered down."