Ruling party powerbroker Ichiro Ozawa pledged bold steps on Thursday to fix Japan's flagging economy if he becomes premier, floating tax cuts and threatening to intervene in currency markets to curb the yen's rapid rise.

Ozawa would likely become prime minister if he defeats Prime Minister Naoto Kan in a September 14 Democratic Party of Japan (DPJ) leadership vote, but the outcome is too close to call. He heads the biggest group of DPJ lawmakers but his scandal-tainted image puts off the public and could affect the vote.

The battle in the party, which swept to power a year ago, underscores a rift that could derail Kan's efforts to curb a public debt already twice the size of the $5 trillion economy.

I think we need to transform the economy into one that does not rely on external demand, Ozawa said in a televised debate with Kan.

Ozawa, a critic of Kan for floating a possible rise in the 5 percent sales tax before a July upper house election that cost the ruling bloc its majority in the chamber, said he had plans for big cuts in income and residential taxes and stressed the need to cut wasteful spending. He did not elaborate.

Ozawa added he was not averse to debating the sales tax, but promised -- as Kan has also done -- not to raise the levy before a lower house election that must be held by late 2013.

I am thinking of big cuts for income tax and residential taxes ... I think it is fine to debate the tax system in general, including the sales tax, he said.

The sales tax is politically a highly sensitive issue in Japan. The last hike, from 3 to 5 percent in 1997, was widely blamed by voters for derailing a nascent economic recovery.

DEBT WORRIES, INTERVENTION THREATS

Ozawa's propensity for economic stimulus has been welcomed by some financial market players worried about Japan's faltering economy, but would also exacerbate concerns about mounting debt and so steepen the yield curve for Japanese government bonds.

He lacks a clear plan on how he will finance this, said Yasuo Yamamoto, a senior economist at Mizuho Research Institute, adding that stimulus could help but only if interest rates do not rise.

The party race coincides with a rise in the yen that threatens Japan's fragile recovery. A Bank of Japan decision on Monday to boost a cheap loan scheme did little to weaken the currency, hovering near a 15-year high against the dollar.

Ozawa, repeating a stance in his policy platform issued on Wednesday, said Japan must be ready to intervene in currency markets to stem the yen's rise, even if it meant going it alone.

Room for further monetary policy steps is limited, Ozawa said. With the global community tolerating a strong yen, it might be hard for solo currency intervention to have an effect. Still, the yen's rise has come to a level where we will need to act with such a determination.

Markets did not react much, and some analysts questioned whether he would talk as tough if he became prime minister.

Ozawa is now in a position outside the government so there is an element of him being able to say what he wants, said Osamu Takashima, chief FX strategist, Japan, for Citibank in Tokyo.

There is no telling if Ozawa will win, and even if he does, there is no guarantee that there will be a change in the foreign exchange policy (of the government), he added.

The DPJ swept to power a year ago for the first time promising change, but it has stumbled on economic and diplomatic fronts, struggling to craft a plan to end decades of stagnation and straining ties with key security ally the United States.

Ozawa said he would respect an existing deal with Washington over the relocation of a U.S. military base in southern Japan but wanted to renew discussions on how to win local support, a move that risks reviving a feud with Japan's closest ally.

(Reporting by Chisa Fujioka, Yoko Nishikawa, Yoko Kubota, Leika Kihara; Writing by Linda Sieg; Editing by Alex Richardson)

Japan