The result, which follows weeks of in-fighting in the coalition government, has split his Liberal Democratic Party and forced Mr Koizumi to call a snap general election that could end his party's decades-long hold on power.
The Economy Minister, Heizo Takenaka, who drafted the bill, called the rejection "a huge loss" to Japan's future, but his opponents were jubilant.
Katsuya Okada, the opposition Democratic Party leader, who said the bill's failure could pave the way for two-party rule in Japan, said: "The result shows the cabinet lacks the confidence even of members of the LDP. For the first time in the post-war period we will openly go head-to-head in elections and we aim ... to take power," he said.
Mr Koizumi promised for years that he would face down the vested interests that protect Japan Post - in effect the world's biggest bank - and dissolve parliament if he failed. Yesterday, 125 lawmakers in the country's upper house, including 22 members of his own party, called his bluff, defeating the 108 votes for the plan.
Technically, the bill could still be passed with a two-thirds majority in the more powerful lower house, but Mr Koizumi rejected any compromise, angering many on his own supporters.
Many analysts doubt whether Mr Koizumi would survive an election. "He has a very slim chance of winning," said Kiichi Murashima, director of economic analysis at NikkoSalomonSmithBarney in Tokyo.Mr Koizumi announced plans to hold elections on 1 September and said he would ban party members who voted against his bill from standing, unless they reversed their position. The move threatens to further weaken a party that has been in power almost continuously for half a century but which in recent years has been in slow decline.
The post office boasts $3.2trn (£1.8trn) in savings and insurance assets - larger than Britain's entire GDP. It employs more than 250,000 people and has 24,700 branches, almost 10 times the number of Japan's seven big national banks. In many villages, it is the only financial institution.
For decades, Japan Post's reservoir of cheap money has been ladled into the Ministry of Finance to fund public works, and help buy the country's enormous public debt in the form of government bonds. The neoliberal economists who surround Mr Koizumi say it is a bastion of waste and corruption that needs a good dose of the market to cure its ills. But such views have little obvious support in Japan, where the postal system is popular and efficient, and it enjoys serious political clout, even within the Liberal Democratic Party, which relies on it for money and votes. Mr Koizumi tried to persuade his LDP colleagues that privatisation would shift more money to the private sector, and pay better interest to post-office savers.
The collapse of his centrepiece reform leaves Mr Koizumi's political legacy in doubt. He has failed to cut public debt, which is estimated at between 150 and 200 per cent of the country's GDP - and growing, or to stop Japan's slow economic decline, seriously overhaul the creaking political system or tackle Tokyo's deteriorating relations with China and Korea.
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