But decisions will only be taken in March along with a strengthening of the currency bloc's rescue fund, on which much work remains to be done, EU officials said.
On the eve of the Brussels summit, Spain's reforms won a vote of confidence from the previously sceptical German leader, who said during her visit to Madrid: "Spain has now really done its homework and I therefore believe Spain is on a very good track."
Spain, which faced pressure in the bond market last year, has taken tough austerity measures, begun to restructure and recapitalise its ailing savings banks, partially reformed its labour market and clinched agreement on raising the retirement age.
Financial markets rewarded Madrid on Thursday with sharply lower borrowing cost at an auction of two- and five-year bonds, illustrating easing tensions as investors expect decisive action to draw a line under the eurozone crisis in the coming weeks.
A source in French President Nicolas Sarkozy's office said Paris and Berlin wanted the 17 states that share the euro to take a series of commitments to make their economies more competitive, to be reviewed at annual euro area summits.
"We are at a key moment, markets are turning, doubts about the solidity of the euro and the euro zone are dissipating. This is the moment to take a great step forward," the presidential source said, briefing reporters on condition of anonymity.
The package will balance German demands for stricter fiscal discipline, backed by sanctions, with French calls for regular eurozone summits to build a "European economic government" and coordinate growth-oriented policies.
The proposed "competitiveness pact" would entail commitments to anchor deficit curbs in national constitutions, make wages and labour markets more flexible, and link pension systems to each country's demography, the French official said.
Merkel is determined to achieve binding commitments to such German-style economic reforms in exchange for agreeing to beef up the eurozone rescue fund, which is politically unpopular at home and faces scrutiny from Germany's constitutional court.
Berlin will agree neither on the European Stabilisation Mechanism (ESM) nor on strengthening the European Financial Stability Facility without an agreement on the competitiveness pact, reports EurActiv Germany. "No pact, no German money," said a German government representative.
Sanctions?
Both countries say the European Commission should monitor competitiveness indicators and an annual eurozone summit should review progress. But while Berlin wants compliance enforced by financial sanctions, Paris argues the pledges will be voluntary and not subject to EU disciplinary procedures.
To avoid another failure, Berlin relies on "peer pressure" and a possible new regulation based on Article 136 in the European treaty. This regulation could provide sanctions in case states breach the agreements, writes EurActiv Germany. The Commission should organise "naming and shaming" based on an Annual Growth Survey, said a German official.
Pact open to all
Merkel said the pact should be open to all EU members who want to join, raising the prospect that central European states close to Germany that have not yet joined the single currency might sign up to bolster their market credibility.
EurActiv Spain reports that Zapatero endorsed Merkel's plan, despite relations with the conservative German leader were tense at the height of the eurozone crisis last year.
In return, Merkel praised a landmark agreement signed this week by Spain's Socialist government, trade unions and employers on pension reform and employment, saying it was politically helpful to achieve such reforms by consensus.
France said earlier this week it would propose a constitutional amendment on deficit reduction in the coming months, but the government lacks the required three fifths majority to enact the change without support from opposition Socialists.
Berlin is also seeking to end the automatic indexation of wages to inflation, which exists in Belgium and Portugal and to a lesser extent in France for the minimum wage.
In a sign of the sensitivity, a French source told Reuters there was no question of de-indexing the French minimum wage since it was a social safety net.
Tax harmonisation?
Germany and France are also considering ways to harmonise corporation taxes along the lines of Europe's two agreed bands for Value Added Tax.
France, which has vocally criticised Ireland's low corporate tax rate, favours setting a minimum threshold for tax on businesses across the region. That would be anathema to Dublin, which is counting on attracting foreign investment to revive its shattered economy.
Under the EU treaty, tax policy is subject to unanimity, and EU partners promised Ireland it would remain free to set its tax levels to secure Irish ratification of the Lisbon Treaty in a second referendum in 2008.
European Parliament has no say
According to German sources quoted by EurActiv Germany, the "pact" deals with national matters - so the European Parliament has necessarily no say. "The governments have to answer to their national Parliaments," he said.
(EurActiv with Reuters and network partners in Germany, Slovakia, Spain and Czech Republic.)
