By Leika Kihara and Stanley White
TOKYO (Reuters) - Japan's economic growth slowed more than expected in the second quarter, offering ammunition to those seeking to temper a planned sales-tax increase even as government debt has risen past 1,000 trillion yen ($10.4 trillion).
But as the sharp slowdown was driven by an unexpected fall in corporate capital spending while personal spending remained hardy, the data may encourage Prime Minister Shinzo Abe to proceed with the tax hike and soften the pain by offering tax breaks to boost business investment.
The sales-tax rise is meant as a first step toward tackling Japan's enormous public debt.
The world's third-largest economy grew by an annualized 2.6 percent in April-June, government data showed on Monday, a third straight quarter of expansion but below both market expectations of 3.6 percent growth and a downwardly revised 3.8 percent rate in the first quarter.
Abe, whose top priority has been to spur growth and pull Japan out of 15 years of deflation, faces in coming weeks what he has called the tough decision of whether to go ahead with the tax increase.
Under a multi-party agreement last year, the tax is to rise to 8 percent from 5 percent next April and to 10 percent in October 2015. But the government must certify that the economy is strong enough to withstand the pain of the fiscal tightening.
The premier is to decide by early October, and government officials have flagged the April-June GDP, and its revision on September 9, as key factors.
"The economy has been steadily rising since the inauguration of the Abe administration last year," Abe told reporters.
"I'll continue to take all possible care about the economy. I'd like to focus on the economy, including implementation of further growth strategies in the autumn."
Abe's government is divided on the sales tax, with reflationist advisers urging him to delay or water down the increase and the Finance Ministry avidly urging him to proceed, given the nation's dire finances.
Public debt exceeded 1 quadrillion yen -- or 1,000 trillion yen, about double GDP, for the first time in June.
The reflationist camp jumped on the weak GDP data.
"There is no need to raise the sales tax in a hurry," Koichi Hamada, an adviser to Abe and a professor emeritus at Yale University, told Reuters.
But economists noted that growth remains robust. Some, like Mari Iwashita at SMBC Nikko Securities, said GDP is more likely to be revised up than down because the two weakest elements, capital spending, are the ones that typically change the most.
"At the moment Japan's growth is still the fastest among the developed economies, thanks partly to 'Abenomics'," Iwashita said.
STRONG SPENDING, WEAK INVESTMENT
Economy Minister Akira Amari said the data offered "good numbers for making a judgment on the tax increase." But he expressed concern about the sixth straight drop in capital spending.
The top tax officials in Abe's coalition parties recently told Reuters that the premier would go ahead with the scheduled tax increase and that the open consideration of a delay was partly political theatre aimed at getting the finance and other ministries to approve fiscal stimulus measure.
Targeted tax cuts to boost business investment as well as a cut in corporate tax rates are two of the most prominently discussed measures.
Bank of Japan Governor Haruhiko Kuroda has said the tax hikes are needed and would not hurt the economy. Kuroda has also said Japan can raise taxes and still escape deflation.
The Nikkei 225 share average fell to its lowest since the end of June as confidence was hit by the combination of weak capital spending and the expected sales tax increase affecting consumption, but the market pulled off its lows, ending down 0.7 percent.
On a quarter-to-quarter basis, Japan's economy grew 0.6 percent in April-June. External demand added 0.2 percentage point to growth, while domestic demand contributed 0.5 point.
Private consumption rose 0.8 percent from the March quarter, more than a median market forecast of a 0.5 percent increase, on robust spending on food, travel and consumer electronics.
But capital expenditure slid 0.1 percent, much weaker than a median market forecast for a 0.7 percent increase and marking the sixth straight quarter of decline.
(Additional reporting by Tetsushi Kajimoto, Shinichi Saoshiro and Chris Gallagher; Editing by John Mair, William Mallard, Kim Coghill)