Q+A: What would a credible fiscal plan in Japan need to say?

TOKYO (Reuters) - Japan's new government will unveil a strategy to fix its tattered finances on Tuesday in an effort to reassure investors that it will cut back the country's massive debts.

Prime Minister Naoto Kan says the debt is the "biggest issue that the country must tackle" and the country risks a default if it fails to deal with it.

The strategy will consist of a medium-term fiscal plan that includes binding caps on spending for the state budget over the next three years, plus a set of longer-term targets to bring the primary balance into surplus.

One aim will be to reduce the ratio of outstanding public debt to GDP, which at around 200 percent is the biggest in the developed world.

The government needs to lay out a credible plan to keep the support of investors longer term and avoid a credit ratings downgrade. Investors have expressed concerns about Japan's fiscal outlook through the credit default swaps market.

Following are questions and answers on what markets see as necessary for the strategy to be credible:

HOW QUICKLY SHOULD JAPAN TARGET A PRIMARY BUDGET SURPLUS?

The government has projected a primary deficit, the budget balance excluding revenue from bond sales and debt servicing costs, of 33.5 trillion yen ($370 billion) for the current fiscal year that started on April 1.

Japan should aim to bring that to surplus in the next five to 10 years, economists say.

Promising to erase the deficit any sooner would be unrealistic, while setting a longer timeframe would not lower the overall debt burden, they say.

The Nikkei newspaper reported that the government aimed to bring the deficit into surplus by March 2021 -- the limit of that five to 10 year range.

But Finance Minister Yoshihiko Noda said that the report was "clearly wrong" and that the government had not finalized its plans.

"The government ideally should aim for a primary balance surplus in five to seven years. Ten years would be too long. If the current economic recovery continues, it would be possible to achieve the surplus within five years," said Seiji Adachi, senior economist at Deutsche Securities in Tokyo.

Yasuo Yamamoto, senior economist at Mizuho Research Institute in Tokyo, said it was important to create a feasible mechanism to cut the fiscal deficit in the medium to long term.

"The initial goal would be a primary balance target and cutting deficits to half in the next five years and achieving surplus within 10 years is desired," Yamamoto said.

HOW LONG SHOULD JAPAN TAKE TO LOWER THE DEBT-GDP RATIO?

They key issue is for the government to commit to a timeframe for cutting the primary budget deficit.

It needs to commit to reducing the debt-GDP ratio over time but specific increments tied to dates are not needed. The reasoning is Japan cannot lower the debt-GDP ratio without first returning to a primary budget surplus.

Investors should focus more on how aggressive the timetable is for the primary budget surplus and monitor the government's fiscal policy to see if it is on track, economists say.

SHOULD THE GOVERNMENT CAP NEW DEBT ISSUANCE?

Japan will pledge to cap new bond issuance next fiscal year at the record 44.3 trillion yen earmarked for this year, National Strategy Minister Satoshi Arai has said.

As finance minister, Prime Minister Naoto Kan had said he wanted to cap new bond issuance at that level.

Economists and credit ratings agencies say it's important for the government to underline its intention to cap new bond issuance in the fiscal discipline plan, but it would be imprudent to aggressively lower the cap in the next year or two. The government needs to allow some leeway for economic growth to become established following the shocks of the global downturn.

"Our view is that Japan's ratings will come under downward pressure in the medium term unless the public finances get on a sustainable footing," said Andrew Colquhoun, director in Fitch's sovereigns ratings team in Hong Kong.

"Whether 44.3 trillion yen is achieved or not this year is secondary to that question. The framework needs to have enough flexibility to cope with the unexpected, and should be transparent about how a consolidation path would be restored even if a negative shock requires some departure for a period."

SHOULD THE GOVERNMENT SAY IT WILL RAISE THE SALES TAX?

Yes. But it won't.

The sales tax, applied to the retail sales of items including clothes and food, is currently just 5 percent, lower than other major economies.

For years, successive governments have danced around the issue, fearful of committing to a rise in the tax in case voters turn against them.

The government needs to commit to raising the sales tax to 15 percent or even 20 percent over the next 10 to 15 years to pay for the rising social welfare costs of a rapidly aging population, economists say.

However, markets already fully expect the government to fudge the issue once again by making a vague reference to beginning a debate on tax reform at some point in the future.

Opinion polls have shown that the public is willing to accept a higher consumption tax to pay for rising healthcare costs. But many ruling party lawmakers are reluctant to pledge a sales tax hike ahead of the July upper house election.

SHOULD THE GOVERNMENT CUT HEALTHCARE SPENDING?

Japan's aging population means healthcare costs will inevitably rise, so promising to lower welfare spending is needed, economists say.

But the government will struggle to lower welfare spending unless it encourages more private-sector participation in healthcare, economists say.

(Editing by Neil Fullick)

(Additional reporting by Rie Ishiguro, Kaori Kaneko and Charlotte Cooper)