BERLIN (Reuters) - German Chancellor Angela Merkel's conservatives are expected to retain power in a state election in Hamburg on Sunday, but the big winner may be a new far-left party that has profited from a national tax dodging scandal.

Polls show that Ole von Beust, a member of Merkel's Christian Democrats (CDU) who has ruled the city-state since 2001, will lose his absolute majority in parliament but hold onto power by forming a coalition, possibly with the environmentalist Greens.

That partnership would be a first at state level and, if successful, could persuade Merkel to venture such a liaison at national level when she seeks re-election in 2009. She currently heads an uneasy grand coalition with the Social Democrats (SPD) who have dominated the left in the post-World War Two era.

Voting in the northern port city of 1.7 million gets under way at 8 a.m. (7:00 a.m. British time) with the first exit polls due to be published at 6 p.m. (1700 GMT).

Hamburg, the country's second biggest city after Berlin, is home to some of Germany's wealthiest people as well as a large number of immigrants and blue-collar labourers, who work at the port and in a large Airbus factory.

It was ruled by the centre-left SPD for over four decades before von Beust wrested control from them seven years ago.

SOCIAL SPLIT

In a bid to win back the former stronghold, SPD candidate Michael Naumann, a former culture minister under ex-Chancellor Gerhard Schroeder, has vowed to heal the "social split" he says exists between Hamburg's rich and poorer communities.

But he has found himself fighting off a left-flank assault from the Left party, a new grouping of ex-communists and SPD deserters, which did surprisingly well in state votes in Hesse and Lower Saxony last month and may do even better in Hamburg.

The Left, which seeks a generous new minimum wage and curbs on managers' salaries, has risen in the polls since it emerged this month that hundreds of rich Germans may have evaded taxes by hiding cash in secret accounts in Liechtenstein.

The rise of the Left has injected new uncertainty into German politics by making it more difficult for the country's big parties, the CDU and SPD, to form ruling coalitions with their preferred partners.

This situation has forced them to consider previously unheard of partnerships. The SPD's national leader Kurt Beck, for example, is mulling using Left party votes to get his party's candidate elected premier in Hesse after a deadlocked vote there in January.

That has set off a storm of protest by moderate members of Beck's own party who see the Left as unreliable populists. The infighting in the SPD over whether to work with the Left in Hesse could end up tainting their result in Hamburg.

Hamburg could become the first German state to be ruled by a coalition of Christian Democrats and Greens after a regional election gave neither centre-left nor centre-right an outright majority on Sunday.

Exit polls gave Ole von Beust, the CDU mayor of the northern city-state, about 43 per cent of the votes, the best result of all candidates, but showed him holding too few seats to form a government with the free-market Free Democratic party.

Angela Merkel, the chancellor and CDU chairman, is likely to encourage Mr von Beust, who has so far ruled with an absolute majority, to seek an alliance with the Greens, traditional allies of the Social Democratic party.

Analysts said such a “black-green” government, the first in German history, would serve as a test of the two parties’ ability to work together ahead of the 2009 general election, when the CDU can no longer afford to rely only on the FDP as a coalition partner.

Opinion polls on Monday suggest the 2009 vote could yield a tie for the second time in a row, forcing CDU and SPD to try new coalition permutations or rule again together in a “grand coalition”.

A recent opinion poll showed nearly 60 per cent of Green voters favoured a “black-green” experiment at the regional level. Yet CDU and Greens are far apart politically and the coalition talks in Hamburg could be protracted.

The radical Left party was credited with 6.5 per cent of the vote on Sunday night, continuing its march into the country’s regional parliaments.

The emergence of a fifth party in Germany’s four-party system has upset the country’s political arithmetic, making it difficult for others to achieve the majorities needed to form traditional FDP-CDU or SPD-Green governments.

This resulted in the formation of Germany’s first “grand coalition” under Ms Merkel after the inconclusive election of 2005. In the state of Hesse, Roland Koch, the incumbent state premier, has yet to form a government one month after a ballot that delivered a similar outcome.

Kurt Beck, chairman of the SPD, was last week reported to have, for the first time, floated the possibility that the SPD’s defeated candidate in Hesse could form a minority government with the Greens and the tacit support of the Left party.

The apparent break with his hitherto categorical refusal to rule with the Left party caused an outcry in the SPD leadership. Jürgen Falter, professor of political science at Mainz University, said the controversy might have robbed the party of precious votes in Hamburg.

“There was a discussion last week that seems to have created some confusion,” Mr Beck said on Sunday night. “If I contributed to this, I regret it.”

Exit polls on Sunday night gave the SPD 34 per cent of the votes, an improvement on its last result but a disappointing score in a city that has historically been a Social Democrat stronghold.