Japan's consumer spending and production slumped more than expected in response to last month's sales tax increase.
The decrease has raised questions about the pace of economic recovery and highlighting the need for reforms to sustain growth once the tax shock fades.
The International Monetary Fund expressed its confidence today that the world's third-largest economy will pick up again in the second half of the year.
However, it also called for more vigorous efforts to dismantle barriers to faster growth that have kept Japan trapped in nearly two decades of stagnation and deflation.
The tax sales tax increase, to 8% from 5%, is part of an effort to complement a burst of monetary and fiscal stimulus unleashed last year by Prime Minister Shinzo Abe and his team to stabilise Japan's stretched finances.
As widely anticipated, the take increase produced a drop in spending after an earlier rush of purchases, especially of high-ticket durable items, like washing machines and cars.
But while the economy's first quarter performance beat expectations, driven by strong capital investment, the subsequent drop was sharper than most economists had forecast.
Government data showed today that household spending fell 4.6% in April from a year ago, more than the median market forecast for a 3.2% drop.
That marked the fastest annual decline since March 2011, when Japan suffered a massive earthquake, a deadly tsunami and a nuclear disaster
Compared to the previous month, spending tumbled by a record 13.3% in April, more than the 13% decline expected by economists. The figures followed a similarly steep drop in April retail sales reported earlier this week.
The data showed that the impact was bigger than in 1989 when the 3% sales tax was first introduced and in 1997, when it was raised to 5%.
But while analysts said the figures suggested the return to growth might be slower than businesses had hoped, both private economists and the IMF remained optimistic that the economy will start recovering in coming months.
"Although the consumption payback in the second quarter will lead to a sharp growth contraction, we expect the recovery to resume in the second half of the year with further job growth and rising wages supporting moderate consumption growth," the IMF said in a statement following an annual review of Japan's economy.
David Lipton, the first deputy managing director of the IMF, said there was no need for the Bank of Japan to step up its asset buying monetary stimulus and that the yen currency broadly reflected the economy's fundamentals.
With the BOJ's efforts succeeding in reviving inflation and the negative impact of the sales tax increase expected to fade, the IMF's biggest concern was whether Tokyo will act forcefully enough to remove barriers to growth, Lipton said.
So far pro-growth steps making up the "third arrow" of Prime Minister Shinzo Abe's economic revival plan dubbed Abenomics have met with lukewarm reception from investors and businesses and another instalment is due in late June.
"Our main concern is that the third arrow of Abenomics be fired forcefully. We believe that potential growth (over the medium-term horizon) in Japan has continued to decline," Lipton said.
The Fund noted progress in some areas such as energy sector deregulation, changes to farm subsidies, agriculture financing and the government pension fund, and Japan's participation in talks on the Trans-Pacific Partnership trade pact.
But it also produced a long list of areas where it urged more vigorous action to remove barriers to growth that "perpetuate a deflationary mindset and passive firm behaviour."
Among those are steps to boost labour participation of older workers, women and foreign workers, improving entrepreneurs' access to risk capital, governance reform and deregulation of agriculture and services.
The Fund also reiterated its long-held position that Tokyo not only should raise the sales tax again to 10% in October 2015 as planned, but also bring the levy to 15% over the longer term.
It also said Japan urgently needed to come up with a post-2015 plan to rein in ballooning debt that has reached 240% of its annual economic output - a record among industrial nations.
Without structural reforms and budget consolidation, too great a burden would lie on the Bank of Japan and monetary policy, which could lead to financial instability, the IMF warned.