Germany, the EU's largest economy, is expected to exceed the EU Stability and Growth Pact's budget deficit ceiling of 3 percent of GDP in 2005 for the fourth year in a row. It will almost certainly breach the rules in 2006 as well.
"We can't just simply ignore the European Stability and Growth Pact," Merkel told an audience of construction industry leaders.
"You know that Germany is a violator of the Stability and Growth Pact and is now facing proceedings for breaching it, proceedings that could be brought to another level," she said, adding Germany must reduce its deficit to below the EU ceiling.
Merkel's conservatives (CDU/CSU), who narrowly won last month's general election, are in talks to form a government with the centre-left Social Democrats (SPD). They aim to have Merkel in office and a government in place by the end of November.
Both parties agree that it is necessary to bring German public finances in line with euro zone regulations and aim to slash Germany's structural deficit by around 35 billion euros ($42.4 billion) by 2007.
However, they disagree on how to achieve this.
The SPD and CDU/CSU are expected to make a decision next week on whether the country's value-added tax (VAT) should be increased, a decision that polls show few Germans would welcome, but most expect.