* Parties hope to settle most issues by Friday
* FDP ready to settle for less ambitious tax reform
* Greens don't insist on fixed date for coal-fired plants
* Greens water down demand for ban on combustion engine cars
* Bavarian conservatives still sceptical (Adds conclusion of day's talks, Friday target)
By Michael Nienaber and Andreas Rinke
BERLIN, Nov 7 (Reuters) - Chiefs of the parties aiming to form Germany's next government hope to agree the outlines of a coalition deal by the end of the week, they said on Tuesday, after two smaller parties broke a logjam by dropping demands on tax and climate policy.
With the three camps still divided on several issues, the pro-business Free Democrats (FDP) offered ground by saying they would accept more modest income tax cuts than a campaign pledge of 30-40 billion euros ($35-46 billion) of relief.
The ecologist Greens also offered a concession, saying they would no longer insist on fixed dates to shut down coal-fired power stations and to ban cars with internal combustion engines.
However, the Christian Social Union (CSU), the Bavarian sister party of Chancellor Angela Merkel's Christian Democrats (CDU) was sceptical about the concessions offered.
"Abandoning nonsense deadlines is hardly a compromise," the CSU's chief negotiator Alexander Dobrindt said after the conclusion of talks on Tuesday.
The three camps agreed to leave smaller expert groups to thrash out compromises on the areas dividing them this week, with top officials, having identified problem areas, only returning to the table on Friday.
"We are now switching to work mode," Michael Kellner, a top Green official.
The three-way coalition the parties are trying to form is untested at national level, and the negotiations follow a fracturing of the vote in a national election in September, when Merkel's conservatives bled support to the far right.
Should the talks stall, Berlin would face a lengthy period of uncertainty at a time when many in the European Union are looking to Germany, its biggest economy, for leadership on issues ranging from euro zone governance to trans-Atlantic relations.
Merkel, who is seeking a fourth term, said on Monday that immigration and climate policy were the most contentious topics in the exploratory talks, which she hopes to advance to full-blown negotiations on Nov. 16.
There is broad support among her conservatives comprising the CDU and CSU for tax reforms. The CDU/CSU alliance also reached a deal on migrant policy last month.
The main sticking point to a broader deal on that front is a conservative proposal to cap at 200,000 a year the number of migrants Germany would accept on humanitarian grounds. The Greens reject such a limit, which they say is unconstitutional.
Also complicating the path to a coalition deal, negotiators will need to seek approval from their parties before proceeding to full-blown talks.
A crucial test will be a Greens party conference on Nov. 25, when party leaders will seek the blessing of their base.
Signalling a readiness to compromise, Greens co-leader Simone Peter told Rheinische Post newspaper: "For us, it doesn't matter if the last coal-fired power station is off the grid in 2030 or 2032. That's where we are pragmatic."
But it was crucial to agree on further climate protection measures to cut Germany's CO2 emissions by 40 percent from 1990 levels by 2020, as Merkel had promised.
Greens co-leader Cem Ozdemir signalled readiness to compromise on car policy after an emissions scandal at Germany's leading automaker Volkswagen plunged the industry into crisis.
"It's clear to me that we alone cannot enforce the end date of 2030 for the approval of combustion engines," Ozdemir told Stuttgarter Zeitung and Stuttgarter Nachrichten newspapers. (Writing by Joseph Nasr; Editing by Paul Carrel and Gareth Jones)