UPDATE 1-IMF calls for gradual rise in Japan sales tax

* IMF:Japan should gradually increase consumption tax

* Country should start fiscal reform in 2011

* Japan recovery gaining momentum, deflation to end late 2011

TOKYO, May 19 (Reuters) - Japan should start fiscal consolidation next year, including gradually raising the country's sales tax, taking advantage of solid growth now, the IMF said on Wednesday.

The recommendation by the International Monetary Fund contradicts Prime Minister Yukio Hatoyama's pledge not to raise the sales tax rate at least until the next lower house election, which does not need to be held until 2013.

"With global scrutiny of public finances increasing, the need for early and credible fiscal adjustment has become critical," the IMF said after its annual review of Japan's economy and economic policies.

"In our view, fiscal adjustment should start in 2011/12, beginning with a gradual increase in the consumption tax, to take advantage of cyclical recovery," the IMF said.

Japan's outstanding debt as a ratio of gross domestic product is the highest among industrial nations.

Investors are on edge over countries with large debt burdens after a crisis of confidence in Greece's fiscal policy roiled financial markets and prompted the European Union to roll out a $1 trillion rescue package to defend the falling euro.

Some market players think Japan could become the next target of markets, although many market players think the country can muddle through at least in the near future because of huge domestic savings.

"Our assessment is that there's limited risk of any kind of sovereign debt event (in Japan). But no matter how small the risk is, it must be a bit higher as a result of recent events. That suggests a need for early action. The fact that the economy is showing strength now shows it is a propitious time to begin adjustment," an official at the IMF said.

The IMF said the Japanese recovery is gaining momentum and that prices in the country will start rising in late 2011.

GDP data due on Thursday is expected to show the economy grew an annualised 5.4 percent in the first months of this year. [ID:nTOE64504A]

The IMF also said the BOJ's easing steps have helped stabilise financial markets and support the economy.

But it added the BOJ could consider additional easing measures such as extending the maturity of the central bank's fund-supplying operations. (Reporting by Hideyuki Sano; Editing by Joseph