By Farah Master and Nathan Layne

Moves towards legalising casinos in Japan have reignited a debate over the legal status of pachinko, with a potential new tax mooted for a $200 billion gaming industry that has existed for decades on the fringes of the law.

Pachinko, a slot-cum-pinball form of gambling, is a national obsession, with one in six Japanese playing the game, though that number is declining as younger generations prefer to play games on their mobile phones.

With past links to organised crime, pachinko is not classified as gambling, which is illegal in Japan. Instead it's treated as an amusement activity like arcades and hostess bars, and the operators of pachinko parlours that are found in city streets across Japan pay no gaming tax.

As some lawmakers push to allow casinos that would contribute billions of dollars to state coffers, pachinko, too, could come under a new regulatory umbrella. Takeshi Iwaya, a leading proponent for casinos from the ruling Liberal Democratic Party, reckons any move to change pachinko laws should come once casinos are up and running, which could be as early as 2020, when Tokyo will host the Olympic Games.

While years away, such reforms may have greater implications for the pachinko industry than the likely loss of customers to new casino resorts, analysts say. And reforming the industry won't be easy given the web of special interests involved, not least the national police agency which oversees it.

"I see no easy way out for the pachinko industry," said Ichiro Tanioka, an expert on Japanese gaming industries and president of the Osaka University of Commerce, a leading proponent in the casino debate. "It's a mess."

One law to rule them all

In pachinko, players buy baskets of small silver balls which they feed into the machine and guide into a hole that spins out numbers or characters on an electronic screen. Matching series win the player more silver balls, which can be exchanged for snacks, alcohol or small items in the pachinko hall.

Most players, however, opt to trade in their winnings for "special prizes," which they then swap for yen at small booths outside, but close to, the hall. Legally, these booths are separate from the hall operator, skirting anti-gambling laws.

The police stop short of fully endorsing this system as legal, placing it in a regulatory grey zone that has effectively barred pachinko hall operators from listing their shares on a Japanese stock exchange.

To help bring the game out of the regulatory shadows, a lawyer with ties to the industry suggested a "pachinko law" allowing balls to be exchanged for cash inside pachinko halls. The main lobby group for parlor operators, though, wants to keep the existing system, but give it legitimacy through a state-supervised scheme.

Either plan would generate about $2 billion in annual revenue for the government, according to copies of the proposals seen by Reuters.

Yoji Sato, one of Japan's wealthiest tycoons and chairman of Dynam Japan Holdings, a pachinko hall operator listed in Hong Kong, backs reforms that bring all the industry's moving parts - from machine makers to booth operators - under one law. He acknowledged the industry faces close scrutiny.

"Any industry that cannot be accepted or understood by society will cease to exist," Sato, 68, told Reuters in an interview. "Dynam is in principle behind any move to clarify the industry's role in society."

Battle for survival

Seiko Noda, another LDP lawmaker involved in both pushing for casinos and the pachinko debate, said there is no consensus yet on how best to regulate pachinko.

Among the 4,000 or so firms involved in the industry, the smaller, financially weaker hall operators are more worried about change, and particularly about any new tax scheme, Noda said. "The hall owners are quite afraid they will be ordered to pay more tax to the government, so I'm considering it very carefully," she told Reuters at her office in the government's national parliament building.

Dynam and other leading pachinko operators, meanwhile, are vying to open multi-billion dollar casino resorts - should regulations permit.

A recent Morgan Stanley report predicted that Japan's casino market could be worth $21 to $22 billion - though that's less than half the size of Macau's, and well below a consensus view of around $40 billion, by 2025.

Sato said his focus is on that domestic casino opportunity, adding his company has held talks with casino operators including Macau's Galaxy Entertainment and Melco Entertainment.

Rival hall operator Maruhan and two of Japan's biggest pachinko machine makers, Sega Sammy and Konami, have also met casino operators, industry executives say. To gain experience in the resort business, Sega Sammy is building a $1.7 billion casino in the South Korean coastal city of Incheon with local gaming firm Paradise Co.

At risk

This diversification isn't just driven by potential pachinko reforms.

Pachinko revenues are falling as Japan's population ages and as younger people turn to mobile devices for entertainment. On a recent visit to a brightly-lit pachinko hall in an outlying Tokyo suburb, most of the players were middle-aged men.

Gross pay-ins in the pachinko market have dropped to 19 billion yen ($186 million) from 31 billion yen in the past 20 years, and the number of players halved between 2002 and 2012, according to Morgan Stanley's research.

While pachinko is unlikely to be badly hit in the short term - parlors are informal and widespread, while casinos will be upscale and out-of-town - a recent increase in Japan's sales tax may squeeze small operators and accelerate consolidation.

Kunio Nobuta, a flamboyant billionaire who heads one of Japan's oldest and largest pachinko hall operators, said his Nobuta Group aims to increase its non-pachinko revenues to 30-40 percent from around a tenth now, and may get into real estate.

Haruo Kinoshita, president of pachinko hall operator Kicona, sees smaller operators having to merge as the game's popularity wanes.

"There are few young people playing, they don't have any pocket money. Back in the heyday, people worked hard and played hard. Now everyone's grown up. I'm worried about the future."