Japan should rely primarily on raising the sales tax to generate extra revenue, and may need to raise it to as high as 26 percent to achieve a large primary surplus, the Organisation for Economic Cooperation and Development (OECD) said on Monday.
The national sales tax is scheduled to rise to 10 percent in October, from 8 percent now to help pay for rising healthcare costs.
The Bank of Japan should remain focused on achieving its 2 percent inflation target, but there are signs its purchases of exchange-traded funds (ETFs) are distorting the stock market, the OECD said in an economic survey of Japan.
The OECD's assessment highlights the delicate policy challenges facing Japan. Policymakers need to curb healthcare spending and raise revenue to pay down debt, but this could decrease the chance of fostering sustainable inflation.
"Spending restraint needs to be accompanied by measures to increase revenue," OECD Secretary-General Angel Gurria said.
"The plan to increase the sales tax to 10 percent from 8 percent is essential."
Japan's spending on welfare and healthcare has doubled to 22 percent of gross domestic product from 11 percent of GDP over the past 25 years, which is why increasing revenue is an urgent task, the OECD said.
The country's outstanding government debt is more than twice the size of its $5 trillion economy, another reason Japan needs to pursue fiscal discipline, it added.
Japanese Prime Minister Shinzo Abe's government plans to use a combination of tax breaks, shopping vouchers, and multiple tax rates for food to soften the blow to consumer spending.
The OECD warned that most of the steps will not boost demand and said multiple tax rates for food will benefit high-income households more than low-income households.
The BOJ has engaged in a radical quantitative easing by buying up Japanese government debt and buying ETFs, which are linked to the stock market. The central bank says these steps are necessary to keep rates low and reduce risk premiums.
However, economists and traders have become increasingly worried about the negative side-effects of the BOJ's policies.
The BOJ needs to ensure that its government debt purchases do not drain the market of liquidity, the OECD said, adding that since the central bank now owns more than three-quarters of the ETF market, it can lead to the overvaluation of some stocks.
The ETF purchases also erode market discipline because companies are rewarded simply because they are a member of a benchmark index, and not because of their business strategy, the OECD said.