Japan's government approved a record 92.4 trillion yen ($1.1 trillion) draft budget on Friday for the year from next April, keeping its self-imposed cap on new debt but it faces a tough road ahead to fix its tattered public finances.

With new debt issuance seen topping tax revenues for the second straight year in the initial budget, Finance Minister Yoshihiko Noda reiterated the need to overhaul the country's tax systems -- code for a sales tax hike -- to meet rising welfare costs for the fast-aging population.

Tax revenues are approaching levels of new bond issuance but this situation is abnormal and it is hard to steer finances, so we must escape from this situation, Noda told reporters.

We need to thoroughly explain the need to respond to rising welfare costs and that we cannot avoid a tax overhaul if we are to secure a sense of future security.

Noda added that he hoped the 2011/12 budget, which was approved by the cabinet, would also help to boost the flagging economy and job market to pull Japan out of deflation.

But a divided parliament clouds the outlook for its implementation, creating an additional headache for Prime Minister Naoto Kan as he confronts low voter support and a bitter feud inside his ruling party over scandal-plagued powerbroker Ichiro Ozawa.

The first budget compiled by the Democratic Party-led government from scratch keeps new borrowing at 44.3 trillion yen, in line with its promise to limit fresh debt to this year's level.

The government also adhered to a self-imposed cap on spending, excluding debt servicing, at this year's level around 71 trillion yen, aiming to rein in a public debt that is about twice the size of Japan's $5 trillion economy.

SPLIT PARLIAMENT

The budget is almost certain to be enacted, since the ruling Democratic Party of Japan (DPJ) controls parliament's powerful lower house and the budget would take effect even if rejected by the opposition-controlled upper chamber.

But passage of bills needed to implement and fund the spending, such as one on issuing deficit-financing bonds, is far from certain as they need approval by both houses of parliament. Without such enabling bills, the government could not secure 44 percent of its budget revenues, finance ministry officials said.

Market players are well aware of risks such as a delay in parliamentary deliberations on the budget, said Takahide Kiuchi, chief economist at Nomura Securities.

Although opposition parties are unlikely to take the budget hostage for fear of public criticism, they could win concessions such as resignation of the entire cabinet in return for passage of budget bills.

The Liberal Democratic Party, the main opposition party, wants the government to drop some of its key campaign pledges including payments to families with children, while the government has scaled back such spending plans due to a lack of revenue.

Tax revenues, seen at 40.9 trillion yen, will fall short of new bond issues for a second straight year on an initial budget basis, even as they increased 3.5 trillion yen from this year with the economy's recovery from a deep recession.

To balance the record budget, the cash-strapped government scraped together 7.2 trillion yen of non-tax revenues, the bulk of it by raiding cash reserves from its special accounts and administrative agencies.

Government officials say non-tax revenues are a near-term solution and it will be even harder to compile budgets from next year onwards without a consumption tax hike or deep spending cuts, as welfare costs rise for the fast-aging population.

The government says it will seek to implement comprehensive tax reform in the 2012/13 fiscal year but it could face stiff resistance from ruling party lawmakers wary of alienating voters.

Japan's public debt is expected to reach 891 trillion yen, or 184 percent of GDP, at the end of March 2012, the finance ministry said, the highest among developed nations.

($1=82.96 Yen)

(Additional reporting by Linda Sieg; Editing by Edmund Klamann)

Japan