UPDATE 3-Japan's budget to hit record, but with reduced new bond issuance, draft shows

Adds details, context in paragraphs 5-8, 10

By Takaya Yamaguchi

TOKYO, Dec 25 (Reuters) - Japan's government is set to compile a record $735 billion budget for the fiscal year from April due to larger social security and debt-servicing costs, adding to the industrial world's heaviest debt, a draft seen by Reuters showed.

The 115.5 trillion yen draft budget is being compiled as the Bank of Japan shifts away from its decade-long stimulus programme, putting more burden on the government to stimulate the economy.

In an attempt to improve public finances, however, the government plans to trim new bond issuance next fiscal year to 28.6 trillion yen from this fiscal year's initially planned 35.4 trillion yen, helped by tax revenue growth, the draft showed.

It is the first time in 17 years that new bond issuance will drop below 30 trillion yen.

Decades of stop-start fiscal spending and reform have left Japan with the industrial world's heaviest public debt burden - more than double the size of its annual economic output.

The BOJ's retreat from a decade of radical stimulus adds to pressure on Japan's fiscal health, as the government can no longer count on the central bank to effectively bankroll debt.

The BOJ ended negative interest rates in March and raised its short-term policy target to 0.25% in July. Governor Kazuo Ueda signalled on Wednesday that the next rate hike is nearing, saying wage and price developments indicate the economy will move closer to sustainably achieving the central bank's 2% inflation target next year.

The draft budget, up from this fiscal year's 112.6 trillion yen, is expected to be approved by Prime Minister Shigeru Ishiba's cabinet on Friday for submission to parliament for deliberation early next year.

Tax revenue is projected to rise 8.8 trillion yen from this year's initial estimate to a record 78.4 trillion yen, thanks in part to a recovery in corporate profits, according to the draft.

The primary budget balance, which excludes new bond sales and debt servicing costs, will be in deficit of less than 1 trillion yen, keeping alive the possibility of achieving the government's goal of delivering a primary budget surplus by the next fiscal year.

The budget draft assumes the yield on the benchmark 10-year government bond rises to 2% next fiscal year from this year's 1.9%, topping 2% for the first time in 13 years.

That would boost debt-servicing costs for interest payments and debt redemption to 28.2 trillion yen from 27 trillion yen for this fiscal year.

($1 = 157.2200 yen)

(Reporting by Takaya Yamaguchi, Makiko Yamazaki and Kaori Kaneko; Editing by William Mallard and Raju Gopalakrishnan)

((Makiko.Yamazaki@thomsonreuters.com;))