* Earthquake/tsunami recovery to propel 2012 growth
* Cutting public debt without hurting growth a key challenge
* Labor, power, farm reforms needed to boost growth
By Paul Eckert
WASHINGTON, Aug 1 (Reuters) - Japan's economy is recovering this year on reconstruction from the 2011 tsunami disaster and is likely to grow by 2.5 percent, but faces downside risk from Europe's troubles and slower growth in China, the International Monetary Fund said on Wednesday.
The IMF, in a report on annual consultations with Tokyo, urged Japan to enact a broad package of structural reforms to tackle high public debt of more than 125 percent of GDP, a rapidly aging population, low growth and persistent deflation.
"Reducing the public debt burden is a top priority, but this task is complicated by low growth, persistent deflation, and a rapidly aging population," said the fund.
The IMF said public reconstruction spending of about 1.5 percent of GDP and strong consumer demand would propel real GDP growth of near 2.5 percent this year, but growth would trail off in 2013 to 1.5 percent as reconstruction winds down.
In the short term, Japan faced pronounced downside risk to exports and growth from "escalation of the European turmoil or a sharper-than-expected slowing of the Chinese economy," it said.
Japan's financial system remained stable through the earthquake and Thai floods of 2011, and its banks' exposure to peripheral European countries is tiny, but "indirect exposures through financial ties to core European are significant," it warned.
Over the medium term, a prolonged global economic downturn and failure to advance key structural reforms would mean that Japan would "continue to suffer from low growth and deflation, a toxic mix that would worsen public debt dynamics substantially," said the IMF staff report.
Passing a bill to raise the 5 percent consumption tax to 8 percent in April 2014 and 10 percent in October 2015, which cleared the Lower House of Japan's parliament and is being reviewed in the Upper House is "crucial" to show commitment to fiscal reform and sustain investor confidence, it said.
"FAR-REACHING" REFORM PACKAGE
While praising that tax hike, however, the IMF said much more needed to be done to put Japan's public-debt-to-GDP ratio on a clear downward path.
It recommended Japan aim to achieve an overall fiscal consolidation of 10 percent of GDP over the next decade through a mix of spending restraints and revenue increases.
The IMF acknowledged that the dramatic fiscal consolidation required by Japan's large public debts could dampen growth, unless it was carefully designed and paired with "a far-reaching package of reforms" to ease structural impediments to growth.
It recommended reaching for "low-hanging fruit" in labor market reforms such as boosting Japan's female labor participation rates, raising old-age employment, and boosting the low level of immigration.
Other important constraints to growth that Japan must address include regulations that stifle growth in the healthcare and old-age care sectors, reforms of the electricity and agricultural sectors and more trade integration with Asia.
"The authorities' plan to pursue high-quality free trade agreements with key Asian and European trading partners and join the Trans-Pacific Partnership could be a catalyst for regional integration and reforms in services and agriculture," said the report.