Japan Looks Hard at Trimming Huge Debt .

By YUKA HAYASHI

TOKYO—Will global markets start to treat Japan as the next Greece?

Bond traders up to now have been relatively sanguine about Tokyo’s massive pile of government debt. But that attitude could be tested over the next three months, as Japan’s new center-left government nears a self-imposed June deadline for crafting a plan to get its fiscal house in order. Out-of-control sovereign debt is what plunged Greece into crisis.

The main tool being considered to address Japan’s debt problem is an increase in the nation’s sales tax, which at 5% is currently among the lowest in the industrialized world. In Europe, such taxes run closer to 20%. But members of Prime Minister Yukio Hatoyama’s cabinet also worry that a tax increase could hammer consumer spending and push the country back into recession.

Japan has to do something. Government debt in the world’s second-largest economy has swollen to more than twice the size of its annual gross domestic product, and some analysts question how long Japan can keep borrowing without causing a spike in borrowing costs, or, in a worst case scenario, a default.

Pundits predicting a looming Japanese debt crisis have already set off brief spasms of selling in Japan’s government bonds. Standard & Poor’s in January warned it might downgrade the country’s sovereign-debt rating to levels below those of Chile. Moody’s on Thursday also threatened to cut its view on Japan if the country fails to put together a convincing plan for debt reduction.

“We will be looking closely whether the targets are clearly identified,” said Thomas Byrne, a Moody’s analyst who focuses on Asian government debt.

Tokyo’s promised a “medium-term fiscal framework,” due out in June, should spell out its stance on spending and revenue for coming years.

A committee of a dozen lawmakers and private-sector economists have met every two weeks since late January to prepare the report.

Mindful that many are watching how the government tackles its debt problem, Mr. Hatoyama has backed away from costly promises made during his election campaign, such as eliminating highway tolls and high school tuition. The prime minister’s aides are also putting more pressure on the Bank of Japan to be more aggressive in fighting deflation, the problem seen as the root cause of Japan’s two-decade-long economic malaise.

It’s against this background that Finance Minister Naoto Kan recently started talking about boosting Japan’s sales tax. But it comes with strings attached: The government has repeated a campaign pledge not to implement such an increase until 2013.

Raising the tax could hurt Mr. Hatoyama’s party in future elections, including elections for the upper house of parliament set for July.

The idea is unpopular with voters, especially Japan’s large bloc of senior citizens. But advocates say a tax increase is probably the most effective way to reduce the deficit and secure funds to cover the nation’s ballooning pension and medical costs.

Experts generally agree an increase in the sales tax is inevitable, but differ on how it should be implemented. Some argue any increase should be phased in slowly and not started until it’s clear it won’t kill Japan’s economic recovery.

Japan has gone down this road before. A 1997 sales-tax increase triggered a sharp drop in consumption and was blamed for pushing the economy back into a slump and sparking a broad decline of prices for goods and services in the economy.

The tax idea faces opponents inside the government too. International Affairs Minister Kazuhiro Haraguchi, said, “I’d like to point out boosting tax burdens when [Japan’s] regions and economy are fatigued like this would only result in lower tax revenues.”

But others argue that, done right, a tax increase could aid economic recovery. For instance, Toshihiro Nishibori, a University of Tokyo economics professor, said the government should start raising sales taxes now, but spread it over 10 years by increasing it by one percentage point every year.

This method, Mr. Nishibori explains, will not just soften the blow to consumers but would help reverse deflation by creating inflationary expectations. According to this logic, consumers would be expected to slash spending if the tax is suddenly raised by 10%. But if it goes up gradually, with the knowledge that it will keep climbing, people will continue to spend.

“In this way, a tax hike will work as economic stimulus while at the same time improving fiscal conditions,” Mr. Nishibori said.

Japan’s financial health has deteriorated over the past two decades and, by some measures, Japan’s fiscal health is among the worst among major economies.

The nation’s gross government debts soared to 229% of its GDP this year, compared with 92% for the U.S. and 118% for Italy, according to the International Monetary Fund.

Still, some experts say worries about Japan’s debts are overblown.

“The chance of Japan defaulting on its debt is very small and a spike in long-term interest rates is a risk for a few years down the road,” said Tomoya Masanao, a fund manager watching Japan at bond fund Pimco.

Also working in Japan’s favor is the fact that nearly 95% of its outstanding government debt is held by domestic investors, a group who has few other investment options. In the U.S., foreigners hold roughly a quarter of the outstanding Treasury notes, making the market inherently more unstable.

—Tomoyuki Tachikawa contributed to this article.