TOKYO (Reuters) - Japan should set up a special reconstruction fund to raise more than 10 trillion yen ($124 billion) through debt issuance, which would be repaid via tax hikes, to rebuild areas battered by the March 11 earthquake and tsunami, former Bank of Japan Deputy Governor Toshiro Muto said.

Muto, who was also a top bureaucrat at the Ministry of Finance before joining the BOJ, warned that Japan must not fund reconstruction with borrowing unless there are accompanying moves toward tax increases.
Otherwise, he said, Japan would face diminished market confidence in its fiscal discipline, a spike in bond yields and greater difficulties in raising funds for reconstruction.
""The scheme we have in mind is (for the government) to set up a fund, which would issue bonds and redeem them through tax hikes,"" Muto, who is now chairman of Daiwa Institute of Research, told Reuters in an interview conducted on Friday. The comments were embargoed for release on Monday.
Japan is reeling from the triple disaster of an earthquake, tsunami and prolonged nuclear crisis, with the government struggling to find ways to pay for the biggest reconstruction effort since the aftermath of World War Two.
Tokyo estimates the material damage alone could top $300 billion in the world's costliest natural disaster.
But Muto said the overall damage could top 30 trillion yen ($370 billion) when taking into account the damage from the nuclear crisis in Fukushima. The government should shoulder well over 10 trillion yen of the total cost, he added.
Some ruling party lawmakers have floated the idea of the BOJ directly underwriting reconstruction bond issuance, effectively printing money to pay for reconstruction, but the BOJ has resisted the idea and it was quickly dismissed by cabinet ministers.
Muto, who served as deputy BOJ governor for five years until 2008, echoed concerns about the adverse effects in the market of such a radical step, which is in principle prohibited by law, but said the BOJ could take up reconstruction bonds through its market operations, which would encourage financial institutions to buy them.