By Leika Kihara and Tetsushi Kajimoto
TOKYO (Reuters) - Japanese policymakers indicated they favor tax incentives to lift weak business investment rather than a cut in corporate taxes, as the government signaled confidence its stimulus policies had put the economy on the path to escape deflation.
In its most upbeat view on prices in four years, the government said on Thursday that Japan was approaching an end to deflation as a steady pick-up in the economy allowed more companies to pass on rising costs to consumers.
"Recent price developments indicate that deflation is ending," the government said in its economic report for August, offering a brighter view than last month when it said deflationary pressures were easing.
Prime Minister Shinzo Abe wants to keep that momentum alive, but also needs to decide whether to go ahead with a planned doubling of the sales tax rate which is intended to help contain public debt that has exceeded 1,000 trillion yen ($10 trillion).
Earlier this week, reports suggested a corporate tax cut could be offered to ensure Abe could push through the sales tax rise and still encourage business investment. But on Thursday, ministers denied Abe had ordered them to study the idea.
Finance Minister Taro Aso said cutting corporate tax would do little to offset the pain from the planned sales tax hike.
"Given that only some 30 percent of firms pay corporate taxes, I don't think lowering corporate tax rates would have an immediate impact," Aso told a news conference.
Aso, who is also deputy prime minister, said tax breaks to encourage capital spending could be considered, and the government might look at other steps if the sales tax is raised.
Economics Minister Akira Amari echoed that stance, saying he would prioritize tax breaks to encourage capital spending.
"If there are enough financial resources, corporate tax should be lowered to bring it in line with international standards," he said.
"But given tight resources, we'd like to use them in the way that would strengthen industrial competitiveness," said Amari, who earlier this week said all means available must be taken to boost capital expenditure, a soft spot in an improving economy.
The remarks suggest many policymakers want to keep any cut in corporate tax as a long-term option rather than a quick fix to ease the pain from the planned increase in the sales tax to 8 percent next April and 10 percent in October 2015.
GROWTH STILL FRAGILE
The tax debate underscores the challenge Japan faces in trying to come up with a strategy to both foster an economic recovery and contain its enormous public debt, which is more than twice the size of its economy.
Some lawmakers and business leaders argue a corporate tax cut would increase competitiveness. Among members of the Organization of Economic Cooperation and Development, Japan's corporate tax rate is only exceeded by the United States.
But finance ministry officials have resisted this due to worries about losing revenue as they try to cut debt. Instead, they favor more targeted tax breaks for investment, as suggested by the ministers on Thursday.
The economy grew an annualized 2.6 percent in April-June to mark the third straight quarter of expansion as a pick-up in exports added to sustained strength in consumption.
That bodes well for Abe, who has made an end to economic stagnation among his top policy priorities, and the Bank of Japan, which offered an intense burst of monetary stimulus in April to achieve its target of 2 percent inflation in two years.
However, business investment contracted for a sixth straight quarter in April-June, and there are concerns the sales tax hike could stifle the economic pick-up.
In its monthly report, the government maintained its assessment the economy was picking up steadily and revised up its view on the job market to say it was "improving."
The government said it was too early to declare a sustained exit from deflation, noting that doing so would require more lasting rises in consumer prices.
Consumer prices rose in June for the first time in more than a year, although that was mostly due to higher electricity bills rather than stronger demand.
The government has described the economy as being in deflation since November 2009. Removing the word "deflation" from the report, or declaring that deflation is over, would herald a major success in its battle with price declines.
(Editing by John Mair)