TOKYO (Reuters) - The International Monetary Fund said it was essential that Japan go ahead with a scheduled two-stage doubling of its sales tax from next year amid signs the government is reconsidering the plan out of concern it could derail a nascent economic recovery.
The IMF also called for the Bank of Japan to be ready to expand its asset-buying scheme or shift the mix of assets being purchased if inflation does not pick up as envisaged, or if government bond markets became volatile again.
With Japan's huge public debt leaving the country little room to offer additional fiscal stimulus, monetary policy should be the first line of defense against risks to growth such as weakening exports to China, the IMF said in a detailed report on its annual consultations with policymakers released on Monday.
Japan is due to raise its sales tax in April to 8 percent from 5 percent, and to 10 percent in October 2015. The IMF said the hike was an "essential first step" to fix Japan's fiscal problems, and should not be delayed.
"The absence of credible fiscal and structural reforms could weigh on confidence and undermine the success of the started reforms. This would not only be detrimental to Japan, but also for the rest of the world," the IMF said.
"As Japan's debt would remain unsustainable, a global tail risk of a spike in yields and volatile capital flows would remain on the table."
The central bank has unleashed an intense burst of stimulus to end 15 years of deflation, promising to double the supply of money to achieve its 2 percent inflation target in two years.
Its strategy rests on buying around 7.5 trillion yen ($76 billion) of long-term government bonds per month, as well as risky assets like corporate bonds and trust funds investing in stocks and property.
The IMF said expectations of inflation are rising, a sign the government's efforts are working so far. But the test will be whether markets will eventually expect inflation to reach the government's 2 percent target, Jerry Schiff, the IMF's mission chief to Japan, said in an interview.
"Two percent inflation expectations would signal that the Bank of Japan's efforts are now fully credible," he said. "So we're not there. But we have moved in that direction."
The BOJ should stand ready to boost asset purchases, or shift the composition of purchases to buy more risky assets than government bonds, if risks to Japan's recovery heightened and prevented inflation from picking up, the IMF said in the report.
Japan's public debt is the largest among major industrialized nations at more than twice the size of its 500 trillion yen economy, and the sales tax hike is considered a test of the government's commitment to reform.
Sources have said Prime Minister Shinzo Abe has ordered a study of alternatives to the planned increases to avoid derailing an economic recovery he has tried to foster through a policy mix that has been dubbed "Abenomics".
The IMF has backed Abenomics, which combines aggressive monetary easing and fiscal stimulus with structural reforms. But it has also said Japan must eventually increase the sales tax rate to at least 15 percent and craft a credible fiscal consolidation plan as soon as possible to reduce its debt.
The IMF's Schiff said the hike in the sales tax should move ahead as planned in order to convince investors Japan was serious about tackling its fiscal issues.
"Everybody knows that Japan has a very large debt burden ... and they need to make a down payment on a medium-term plan to bring debt-to-GDP down," he said.
Schiff said the consumption tax could slightly hurt growth next year as consumers scale back purchases, but the effect would be less than the government's projections for a hit to GDP of 0.6 percentage points.
If growth were to slow further due to the tax, Japan could consider other ways of boosting the recovery, such as an investment package or more monetary stimulus.
"But that would be preferable to not going forward at all with the consumption tax, because we think that's really critical for maintaining investor confidence," Schiff said.
The IMF's report estimated that if the sales tax were not increased, Japan's net public debt would rise to around 245 percent of GDP by 2030, compared with 210 percent if the tax hikes was implemented as scheduled.
Still, there are disagreements even within the IMF on the feasibility of the two-stage tax hike plan, according to a statement issued by the IMF's decision-making Executive Board.
Directors of the board "generally supported" Japan's plan to double the sales tax rate by 2015, although a few "expressed concern over the possible adverse impact on growth."
Additional reporting by Anna Yukhananov in Washington; Editing by John Mair and Leslie Adler