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UPDATE 2-Japan's PM climbs down on contentious labor reform after data flaws

* Dropping reform will disappoint business, investors

* Labour reform core aspect of "Abenomics" agenda

* Reforms would also cap overtime, but at high level (Adds bylines, bullets)

TOKYO, March 1 (Reuters) - Japanese Prime Minister Shinzo Abe has abandoned for now a key labor law reform aimed at boosting productivity after admitting data used to support the change was flawed, an embarrassing political climb-down likely to disappoint businesses and investors.

Abe had pledged to pass in the current session of parliament, set to end in June, a package of reforms to increase labor market flexibility and allow a more efficient allocation of resources, a core part of his "Abenomics" recipe for growth.

But after weeks of defending the reforms against opposition attack after the government admitted some supporting data was flawed, Abe confirmed on Thursday that one of the most contentious parts of the package would be dropped for now.

The change would have expanded a system of "discretionary labor" where employees are regarded as having worked a certain number of hours and paid a fixed wage regardless of how long they actually work. The flawed data related primarily to this proposal.

"Weve decided to delete every single element of discretionary labor from the reform bills at this time and have the labor ministry grasp the actual situation once more, and then to debate over again," Abe told the upper house budget committee, confirming remarks to reporters late on Wednesday.

Abe came to office in December 2012 promising to revive the economy with "three arrows" of his "Abenomics" policies: hyper-easy monetary policy, fiscal spending and structural reforms. Critics say he has lagged on the third part of this agenda.

"In economic terms, labor reform was going to be the core of the productivity 'revolution' that he was going to engineer," said Jesper Koll, head of equity fund WisdomTree Japan.

"When you ask 'what else is there?', the answer is a yawning emptiness."

Another part of the package would expand the categories of highly skilled and highly paid professions with no limits on their working hours. That provision remains for now, but is already facing similar opposition attacks. Some members of Abe's Liberal Democratic Party favor cutting out this provision, too.

"Abe is trying to spin in such a way that he can put the blame on the labor ministry bureaucrats, but the fact that he is forced to abandon one of the central pieces of his incoherent compromise bundle of bills will entail a greater consequence than he would like to admit at this point," said Koichi Nakano, a political science professor at Sophia University.

"This is not going to be the end of opposition and media scrutiny and criticisms."

Also included in the proposed reforms is a legal cap on overtime of 100 hours per month - an effort to end phenomenon of "karoshi" - or death from overwork.

Critics on one side of the debate have said that cap would effectively condone a level of overtime that is harmful to workers' health. On the other side, some economists say setting the cap reduces management flexibility.

(Reporting by Linda Sieg and Tetsushi Kajimoto; Editing by Sam Holmes)