The Bank of Japan should stick with its expanded quantitative easing to achieve its inflation target, but this may not be enough to foster sustainable economic growth unless it is coupled with structural reforms, the OECD said on Tuesday.
Japan's government should stay with its plan to double the sales tax to 10 percent, compile a detailed plan to return to primary budget surplus in 2020 and boost revenue from other taxes, the Organisation for Economic Cooperation and Development said.
The size of fiscal consolidation needed means Japan does face the risk of a spike in interest rates that would hurt the financial system due to its large exposure to Japanese government bonds, the Paris-based think tank said.
"The new quantitative and qualitative monetary easing should be implemented to meet the new 2 percent price stability target, although this may not be enough," the OECD said in its economic survey of Japan.
"Pushing ahead with structural reform on a broad front is equally imperative to achieve sustained growth."
The BOJ earlier this month committed to open-ended asset buying to nearly double the monetary base to 270 trillion yen ($2.72 trillion) by the end of 2014 to end 15 years of deflation and achieve its 2 percent inflation target in two years.
At a news conference, OECD officials said they were uncertain when Japan would meet its inflation target but that they were willing to give the BOJ some leeway as long as prices are approaching the target.
"We don't know how quickly it will take for inflation to come back," said Randall Jones, a senior economist at the OECD.
"It would be okay if it took three years. What is important is that the BOJ has committed to continue its policy until the target is achieved."
Haruhiko Kuroda, the BOJ's new governor, has dubbed the policy quantitative and qualitative easing, because the BOJ is greatly increasing the size of asset purchases and changing the composition by focusing on longer-term government debt.
Japan's consumer prices are still showing small annual declines, and many private-sector economists doubt the BOJ can meet its price target by 2015.
The OECD forecast that Japan's core-core consumer prices, which exclude fresh food and energy, will rise around 0.5 percent in the fourth quarter of 2014 from the same period a year earlier.
It is important for Japan to end deflation because this lowers nominal gross domestic product (GDP), which worsens Japan's debt-to-GDP ratio, the OECD said. Japan's debt burden is already the worst among major economies at more than twice the size of its $5 trillion economy.
In order to repair public finances, the government should not use multiple tax rates when raising the sales tax, the OECD said. Some lawmakers have argued that the government should exempt food and other items from sales tax hikes.
Should doubts about fiscal discipline emerge, Japan's financial sector would be vulnerable as government debt accounts for about a fifth of all bank assets, the OECD said.
The OECD did turn more positive on Japan's growth prospects due to expectations for higher private consumption and an increase in capital expenditure as exports recover.
Prime Minister Shinzo Abe's stimulus spending and a decline in the yen also led the OECD to upgrade its forecasts.
Japan's economy will expand 1.4 percent both this year and in 2014, the OECD said. That is higher than its previous forecasts of 0.7 percent growth and 0.8 percent growth, respectively.
Labor market reforms to increase the number of female workers and improve productivity are also needed to help Japan's economy grow faster and help end deflation, the OECD said.
Abe's government will announce an economic growth strategy in June, and investors will look for signs of how far the government will push its structural reform agenda.
Rating agency Standard & Poor's said on Tuesday it saw more than a one-third chance that it would downgrade Japan's sovereign ratings because of uncertainty about whether the government's push to revive growth and end deflation will succeed.
"The continuing prospect of a downgrade arises from risks associated with recent government initiatives and uncertainty of their success," S&P said in a report.
"Japanese Prime Minister Shinzo Abe's plan to lift Japan out of deflation and spur economic expansion - known as 'Abenomics' - has three pillars: bold monetary easing, fiscal efforts to spur growth, and a strategy to induce private sector investment," it said.
"Of the three engines that Mr. Abe foresees reinvigorating the nation's economy, so far only one, monetary easing, has kicked into full gear. The others remain idle."
S&P has an AA- long-term rating on Japan's sovereign debt.
($1 = 99.2900 Japanese yen)
(Editing by Kim Coghill)