Dec. 20 (Bloomberg) -- Japan Prime Minister Yasuo Fukuda may fall short of his goal to cut the world's largest public debt, as the budget deficit widens for the first time in five years.

Spending will rise 0.2 percent to 83.1 trillion yen ($735 billion) in the year starting April 1, according to a Ministry of Finance budget proposal released in Tokyo.

The government will sell 25.3 trillion yen of new debt to help fund the deficit. Borrowing costs will probably increase as yields on 10-year notes climb more than half a percentage point to 2.05 percent, a Bloomberg News analyst survey shows.

``It's worrying that political issues are causing the government to start to lose fiscal discipline,'' said Masaaki Kanno, chief economist at JPMorgan in Tokyo.

Fukuda may struggle to meet his 2011 deadline for balancing the budget as cooling global growth dims the outlook for Japan's export-dependent economy. The ruling Liberal Democratic Party is under pressure to assist ailing regions and elderly voters after it lost control of the Upper House in July.

Debt at the central and local governments will reach 776 trillion yen by March 2009, or 147.2 percent of gross domestic product, up from 772 trillion yen a year earlier, the ministry said.

The yield on the benchmark 10-year bond rose 3.5 basis points to 1.52 percent as of 5:50 p.m. in Tokyo.

Aging Population

The government last year set the goal of balancing the budget through spending cuts as the aging population drives up welfare costs and interest payments on bonds swell. Those expenditures account for half of total budget spending.

Tax grants and other subsidies to local government will increase 4.6 percent next year to aid rural areas, according to the proposal. The government also submitted a plan to provide an extra 895.4 billion yen for the current year's budget.

``They're buying some time but the bigger problems are not being addressed,'' said John Richards, head of debt markets strategy for the Asia-Pacific region at RBS Securities Japan Ltd. in Tokyo. ``There's more longer-term cause for concern in this.''

The so-called primary deficit, the excess of spending over revenue excluding bond sales and interest payments, will balloon to 5.2 trillion yen from this year's 4.4 trillion yen.

``Since the LDP lost the July election, there have been enormous calls for more spending, spoiling efforts to stop pork- barrel projects and consolidate fiscal spending,'' said Takahira Ogawa, director of sovereign ratings at Standard & Poor's in Singapore.

The government yesterday slashed its growth forecast for the current fiscal year to 1.3 percent from 2.1 percent and said the world's second-largest economy will expand 2 percent next year, slower than its August estimate of 2.1 percent.

Waning Exports

Export growth slowed in November, the Finance Ministry reported, as the U.S. housing recession caused shipments to Japan's biggest market to tumble for a third month.

``The government should be pragmatic and balance the need for further fiscal consolidation over the medium term against the more immediate need to support economic growth,'' said Julian Jessop, chief international economist at Capital Economics Ltd. in London. ``The budget deficit is unlikely to improve if the economy is collapsing.''

The government has indicated it will probably postpone plans to raise the sales tax, a key tool to pay for higher welfare costs, until the economy is stronger. The LDP and coalition partner New Komeito last week released a proposal that excluded any mention of when, or how much, the 5 percent tax might increase.

``Fukuda won't be able to deal with the issue of raising the consumption tax, prompting further delay'' in shoring up revenue and funding social welfare spending, JPMorgan's Kanno said.

Koizumi's Legacy

The ministry estimates growth in tax revenue will slow to 0.2 percent to 53.6 trillion yen next year, down from this year's 16.5 percent gain. The government will cut new bond sales 0.3 percent, compared with a 15.2 percent reduction this year.

``It's a budget for growth and reform,'' Finance Minister Fukushiro Nukaga told reporters. ``While trying to boost economic growth, we shouldn't waver on fiscal discipline.''

Junichiro Koizumi, prime minister for five years until September 2006, departed from the LDP's decade-long practice of selling bonds to fund building of roads, bridges and community halls in rural areas, the cradle of the party's voters. Japan's debt more than doubled in the 1990s.

Fukuda, appointed after Shinzo Abe quit in September, plans to chop public-works spending 3.1 percent next year, the Finance Ministry said. Koizumi slashed that budget between 3.5 percent and 10.7 percent each year he was in office. Abe made a 3.5 percent reduction.

Interest Payments

The cost of paying interest and redeeming bonds will total 20.2 trillion yen, equivalent to the economy of Venezuela. A 1 percentage point gain in the yield on benchmark 10-year government bonds will increase those costs by about 1.4 trillion yen next year, the Finance Ministry estimates.

S&P raised Japan's government debt rating in April to AA, the third-highest investment grade, citing sustained economic growth and government debt-reduction efforts, including this year's record cut in new debt sales.

Given the weakened LDP after last July's election, ``the outlook for fiscal reform is becoming uncertain,'' Ogawa said. ``Progress, if any, will be very slow.''

The budget will be approved by the Cabinet on Dec. 24 and submitted to parliament in January for passage by March 31.

To contact the reporters on this story: Mayumi Otsuma in Tokyo at motsuma@bloomberg.netKeiko Ujikane in Tokyo at kujikane@bloomberg.net

Last Updated: December 20, 2007 04:57 EST