REYKJAVIK, Dec 11 (Reuters) - Iceland proposed a record high budget deficit of up to 170 billion Iceland crowns ($1.5 billion) for next year to finance the bailouts of its top banks and a vast public works programme to help the ailing economy.
The proposals, made by the government on Thursday, include a 1 percentage point rise in the income tax rate to 23.75 percent and cuts in spending in non-priority areas to limit the bulging deficit.
Public works programmes are seen costing 41 billion crowns next year, also a record high, even though some road projects have been shelved to save money.
"We are not at the end of the road yet, this is one step of many," Prime Minister Geir Haarde told reporters.
Iceland faces a 10 percent contraction of its economy in 2009, with unemployment set to soar after access to the cheap foreign funding that fuelled the island's growth dried up. Trying to stabilise its currency and banking system, Reykjavik has secured $10 billion in foreign assistance, including a $2 billion lifeline from the IMF.
The government said revenues would be considerably lower in 2009 than anticipated due to lower tax revenues and increased costs, as inflation surged following a sharp crown devaluation.
The government said it aimed to protect the social safety net, education, health and law enforcement, while pushing through cost cuts in ministries and state institutions.
"We will do our best to protect the income of middle and lower level income groups," the finance ministry said.
Foreign Minister Ingibjorg Solrun Gisladottir, who also heads the junior Social Democratic party in government, said it was "obvious" that the economic rescue could not be done "without causing pain" and vowed to "protect vulnerable groups".
The higher income tax rate will narrow the budget deficit by about 7 billion crowns. Municipal taxes will also rise. Without such measures, next year's deficit would reach 215 billion crowns.
The government has said it hopes that Icelandic investors will fund its debt issuance next year, with local pension funds expected to play a major role.
Foreign investors have been forced to the sidelines when Iceland froze its capital accounts to avoid further depreciation of the crown. Analysts say that foreigners still own about $3 billion in Icelandic debt from before the crisis. (Reporting by Omar Valdimarsson, writing by Wojciech Moskwa in Oslo, editing by Mike Peacock)