* Manufacturers' Sept sentiment index +10 vs +20 in Aug
* Service-sector index +22 in Sept vs +19 in Aug
* Manufacturers' mood seen up in Dec, service-sector down
* Reuters Tankan strongly correlates with BOJ tankan
* Exports not strong enough to offset post-sales tax slump (Adds exports data, analyst comment, context)
By Tetsushi Kajimoto and Stanley White
TOKYO, Sept 18 (Reuters) - Confidence at Japanese manufacturers fell the most in nearly two years in September as a tax increase hit the economy harder than expected, while exports slid in August in a further sign that conditions have deteriorated in the crucial third quarter.
This frailty in the monthly Reuters Tankan business confidence, and the shaky outlook, could raise in coming months the pressure on the BOJ to ease policy further and complicate Prime Minister Shinzo Abe's decision on whether to raise the national sales tax again.
The first phase of the tax hike in April triggered a 7.1 percent slump in the economy in the second quarter - the worst contraction since the global financial crisis.
The third quarter data will be crucial for Abe's second-stage tax-rise decision, due by year-end, but some analysts say the Reuters survey suggests that the expected recovery is not taking hold.
"Both external and domestic demand are weak, and things in the summer are clearly undershooting forecasts by the government and the BOJ, eroding business confidence," said Takeshi Minami, chief economist at Norinchukin Research Institute.
In fact, the worsening sentiment in Reuters Tankan, with only a feeble improvement forecast for December, bodes ill for the Bank of Japan's quarterly tankan survey, due Oct. 1, which had been forecast to rebound in the third quarter.
HURDLE FOR SECOND TAX HIKE 'BIT HIGH'
"Even though Prime Minister Abe says he stands 'neutral' on the tax decision, I don't think we are in a situation where the tax can be raised soon. The hurdle is getting a bit high," Norinchukin Research Institutes' Minami said.
With the recovery sputtering and inflation appearing stalled well below the BOJ's target of 2 percent, market speculation is growing that Abe may order a burst of government spending and the BOJ may oblige with further monetary stimulus to bolster the economy enough to allow the tax hike to go ahead.
The Reuters Tankan, which is strongly correlated with the central bank's closely watched poll, surveyed 486 big Japanese companies, of which 285 replied, between Aug. 29-Sept. 12.
"The effects of the decline in demand have proved larger than expected" after the April tax hike, said an executive at a machinery maker. A transport equipment producer blamed the higher tax for cooling demand and worsening business conditions.