Japan’s sales tax debate could hit the Nikkei

Kazuhiro Nogi | AFP | Getty Images

Growing uncertainty about a rise in Japan's consumption tax could be one more reason to stay away from the benchmark Nikkei stock index, which has been knocked down about 6 percent in the past two trading sessions by a strong yen, analysts said.

Japan's consumption tax is due to rise next April but Shinzo Abe is reported to have ordered a study of alternatives to raising the tax, in a sign that Japan's prime minister is seriously reconsidering the controversial plans.

"I would be very hesitant on Japan -- it reminds me of where Yahoo was a year ago where you got a new leader coming in, lots of big plans, all of which look like changes for the better, but it needs to come down to execution and whether all that can unfold and whether it will actually help," Joe Magyer, a senior analyst at the Motley Fool, told CNBC.

(Read More: Here's when to get out of the Nikkei rally)

"If you look at the Nikkei, it's up 65 percent over the past year, and there are some pretty full-bodied valuations despite there not being much tangible growth," he added.

Japan's blue-chip stock index on Monday fell to its lowest level in almost in a month and ended the day more than 3 percent lower on the back of a strong yen. Stocks managed to rebound in early trade on Tuesday, as the yen renewed its pace of declines.

"Further talk of delaying the much-anticipated increase to consumption tax in 2014 is hurting sentiment, as this would represent the first major back-track by the Abe government since it came into power," said Chris Weston, chief market strategist at trading firm IG, in a note.

The Nikkei has been the best performing major equity market so far this year, thanks to overall weakness in the yen, aggressive monetary stimulus and optimism about Abe's plans to revive Japan's economy.

(Read More: A nod to Abenomics: Japan inflation speeds up)

Turning Point?

Analysts said that what Abe does with the sales tax could be crucial to how investors view his economic policies, also known as "Abenomics."

The consumption tax on goods and services is due to rise from 5 percent to 8 percent next April, and to 10 percent in 2015, under the current law. It is seen as key to helping alleviate Japan's high debt burden, but there is concern that a rise in the consumption tax too soon could derail a nascent economic recovery.

"This is a hot-button issue in Japan with significant implications for Abe's reform agenda," said Nicholas Spiro, managing director at Spiro Sovereign Strategy. "If a country with a staggering public debt burden of 240 percent of GDP [gross domestic product] puts off a rise in what is already one of the lowest sales taxes among advanced economies, then there are good reasons to doubt the government's fiscal credibility."

(Read More: Here's what could make or break Abe's reform plan)

Bank of Japan Governor Haruhiko Kuroda said on Monday the sales tax increase would not hurt the economy and was needed to repair public finances.

Data on Monday, meanwhile, showed that Japanese retail sales rose 1.6 percent in June from a year earlier, compared with a 0.8 percent gain in May, but analysts said it was too early to call a turnaround in Japanese consumption.

"It is very early for the Japanese consumer to pick up the baton here. We think this [the sales tax] is a huge mistake," Mark Hibbs, portfolio manager at Adamas Asset Management, told CNBC Asia's "The Call" on Monday.