* Solid upswing lifts tax revenues, boosts budget surplus
* Institutes say fiscal room should be used for reforms
* Solid state finances could facilitate coalition building (Adds details, quotes)
BERLIN, Sept 28 (Reuters) - Germany's next coalition government can count on record budget surpluses over the next two years due to a solid upswing and should use this fiscal room to lower income taxes and social welfare contributions, economic institutes said on Thursday.
The better-than-expected budget figures could help Angela Merkel form a tricky three-way coalition with the pro-business Free Democrats (FDP), proponents of tax cuts, and the Greens after winning a fourth term as chancellor in a Sunday vote. The Greens want to lift spending on education and infrastructure.
"Indications are that this year's overall state budget surplus will rise from 26 billion euros to 28 billion euros," the leading economic institutes said in their joint forecast.
The surplus of all state levels - including federal government, regional states, municipalities and social funds - is projected to soar to 37.3 billion euros in 2018 and to 43.7 billion euros in 2019, they added.
The upbeat projections came after Germany took a first step on Wednesday towards forming a new government when veteran finance minister, conservative Wolfgang Schaeuble, agreed to become president of the parliament, clearing the way for another party to take his job.
The institutes said Germany should utilise the additional fiscal room to improve economic conditions and reform the tax and welfare systems, especially to help low-income workers.
"In light of the high burdens imposed on labour incomes in the form of levies and a particularly sharp increase in direct tax revenues, the focus should be on the income tax rate curve," they said, adding that there was also scope to address social security contributions.
The institutes called for a reform of the state pension system given that German society is ageing fast. They did not spell out what the reforms should be.
"The German economy is undergoing an interim high in terms of potential growth rates, which will turn out considerably lower in the coming decade for demographic reasons," said Stefan Kooths, researcher at the Kiel Institute for the World Economy.
Merkel has ruled out lifting the retirement age to 70 as some in her party have suggested. In her first term from 2005-2009, Merkel introduced a phased increase in the retirement age to 67 from 65 until 2029.
Ifo chief economist Timo Wollmershaeuser told a joint news conference of the institutes that politicians should not dodge the pension debate, urging a further hike in the retirement age.
Pointing to labour shortages in some sectors of the economy, the institutes urged Berlin to increase efforts to integrate more than one million refugees and further reduce hurdles for highly educated workers from other European Union countries.
The institutes said German exporters still faced a threat of protectionism, but the risk had eased since the spring as U.S. President Donald Trump's plans for such steps remained vague.
They added that business conditions for exporters could deteriorate depending on the outcome of Brexit negotiations.
On monetary policy, the institutes urged the European Central Bank to prepare for an exit from its ultra-loose monetary policy, warning that the unprecedented stimulus could bring severe risks in the long-term. (Reporting by Michael Nienaber; Editing by Gareth Jones)