Japan's economy will slow significantly this year after last month's devastating earthquake and tsunami, with the government needing to cut spending from other programs to rebuild the country's battered northeast coast and to ensure faster growth next year, the OECD said on Thursday.

Gross domestic product will expand 0.8 percent this year, the OECD said, down sharply from the 1.7 percent growth previously forecast because of the extensive damage from the March 11 natural disaster, the Organization for Economic Cooperation and Development said in a report.

The economy will then expand 2.3 percent in 2012, faster than a previous estimate for 1.3 percent growth, as reconstruction spending gains pace, the OECD said.

Fiscal expenditure to rebuild infrastructure is unavoidable, but the government still needs to show fiscal discipline and eventually needs to raise the country's sales tax to 20 percent from 5 percent currently, according to the report.

The immediate impact of the horrendous disaster is likely to be large, extending beyond the areas devastated by the earthquake and tsunami, the Paris-based OECD said in the report.

However, the experience of past disasters in Japan and other developed countries suggests that the negative short-term impact on economic output will be followed by a rebound as reconstruction spending picks up.

Japan is facing its worst crisis since World War Two after the 9.0 magnitude earthquake and a tsunami towering more than 10 meters battered its northeast coast, leaving nearly 28,000 dead or missing and triggering radiation leaks at a nuclear power plant.

The government estimates the material damage alone could top $300 billion, making it by far the world's costliest natural disaster.

Shortages of electricity and important parts that manufacturers need to make their goods suggests there will be deep and long-running output disruptions that could harm factories in other countries.

Japan's output could recover by the third quarter of this year, but private consumption could remain subdued for the remainder of 2011 due to weak consumer sentiment, the OECD said.

The government is likely in coming weeks to submit to parliament a 4 trillion yen ($48.5 billion) extra budget to remove debris and build temporary housing. The government will avoid issuing new debt for this budget, but politicians concede that new bond issuance is needed for future spending packages.

Since Japan's public debt is already twice the size of its $5 trillion economy, some lawmakers are also considering raising taxes, but there is still a lack of consensus on the politically sensitive issue.

Deflation will remain an obstacle as the economy won't expand quickly enough to close the gap between supply and demand before the end of 2012, the report said.

If more monetary easing is needed, the Bank of Japan (BOJ) should buy more government debt to lower long-term interest rates, the OECD said. The central bank should also be cautious about purchasing riskier private assets, the OECD said.

The BOJ currently buys 21.6 trillion yen in long-term government bonds from the market each year.

Days after the quake the BOJ doubled to 10 trillion yen a program under which it buys assets ranging from government bonds to private debt, as a pre-emptive step against possible damage to economic activity.

The BOJ is expected to hold off on any further easing at a meeting on April 28, sources familiar with the central bank's thinking have told Reuters. The BOJ's benchmark rate is a range of zero to 0.1 percent.

BOJ board members' understanding of long-term price stability centers on a 1 percent rise in consumer prices. The BOJ should consider raising the lower end of its understanding of price stability to 1 percent, to reduce the risk of tightening monetary policy too soon, the OECD said.

(Reporting by Stanley White; Editing by Joseph Radford)

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