| ERBIL, Iraq
ERBIL, Iraq The Iraqi government's decision to choke off funding for Islamic State by cutting off all wages and pensions in cities controlled by the group has plunged people into hardship and could help the insurgents tighten their grip, officials and residents say.
For a year after Islamic State fighters swept through a third of Iraq, Baghdad continued to pay pensions and salaries of state employees inside the self-proclaimed caliphate.
But since July all such payments have been halted, depriving whole cities' pensioners, civil servants, doctors, teachers, nurses, police and workers at state-owned companies of both their income and some of their last official links to Baghdad.
The move is meant to cut Islamic State militants off from of an income stream they have been skimming to fund their efforts to build a self-sustaining state in Iraq and Syria.
But officials and residents in militant-held areas say it has left residents even more desperate, alienated from a government many feel has abandoned them.
"The government has severed its last tie to us," said Younes Khalaf, a retired border policeman from Mosul, whose pension used to sustain seven people. "The situation has never been as miserable as it is now."
Islamic State, also known as ISIS or ISIL, rules its caliphate across swathes of northern Iraq and eastern Syria with extreme violence and an uncompromising vision of Islam.
It has a number of ways of funding its operations - looting millions of dollars in hard currency from banks, selling oil from captured fields, kidnapping for ransom and extorting or taxing new subjects.
The Paris-based Financial Action Task Force, an intergovernmental body overseeing global efforts to fight money laundering and terrorism financing, identified Iraqi salary payments as a “recurring source of revenue” for the group, potentially providing hundreds of millions of dollars per year.
Government officials concede that cutting off salaries is painful for those affected, but say they cannot continue to effectively bankroll the caliphate.
"We are fighting Daesh and suspending salaries is a part of the war against Daesh," said Ali al-Freji, an adviser at the cabinet's economic committee, using an Arabic name for Islamic State. "Regrettably, in every war there is collateral damage".
State workers will be reimbursed once their areas are "liberated", and those who manage to escape Islamic State territory can claim their wages and pensions elsewhere, the government says.
But Islamic State maintains strict travel restrictions preventing people from leaving the territory it controls, although there are signs more people are escaping since the payments were halted.
Hassan Allaf, deputy head of the Nineveh provincial council, said there could be a "humanitarian catastrophe" unless payments resume. His province is mostly under Islamic State control and the provincial council now operates in exile in the neighboring Kurdish region of Iraq.
Freji, the government economic adviser, estimated as many as 400,000 people were on the government payroll in areas controlled by Islamic State.
Each salary or pension may support whole families of dependents. And the impact is being felt even more widely among others whose livelihoods depend on customers with cash.
In Mosul, a city which had nearly 2 million people before Islamic State rolled in last July, a clothes salesman at the Sarjkhana market said business had dropped by around 70 percent in the weeks since the salaries were withheld.
Several residents of Mosul and other areas under Islamic State control said people were saving money and spending only on basic necessities. Some are selling valuables for cash, although the price of non-essential items has fallen.
Ahmed Fathi, who runs a small shop in Mosul's Bab al-Tob market, said his main customers these days were militants.
"THIS FARCE MUST STOP"
Baghdad has failed to come up with an effective military strategy to defeat the insurgents, who have embedded themselves in Iraq's minority Sunni Muslim community and weathered a year of U.S.-led air strikes.
Previous efforts to cut off the group's funding were also unsuccessful. When Baghdad tried routing payments through a third city, where an authorized person would transfer them through private firms in Mosul, those companies turned out to be controlled by the insurgents.
Islamic State benefited not only from directly skimming off the cash, but indirectly as well. Monthly payments meant the population could afford fuel and cooking gas which the militants tax, and pay for services Islamic State provides, such as street cleaning and drinking water.
"One way or another, it ends up in the pockets of Daesh: this farce must stop," Freji said.
So far, residents and local officials say they have seen no signs of the salary cuts loosening Islamic State's grip. The group lowered some of its fighters' wages by 30 percent around the time the government cut salaries, but it was not clear whether the two moves were related.
Aymenn Jawad Al-Tamimi, a fellow at U.S.-based think tank the Middle East Forum said the cuts would hurt Islamic State financially, but the blow would not be fatal because it had a diversified income.
“The problem is that it is not the only avenue by which there is cash flow between IS and the outside world liable for IS taxation,” Tamimi said.
"Dismantling IS income requires dismantling its state-like structure, which isn't happening in the heartland of its territories any time soon."
In the meantime, some residents say the salary cuts could work in the militants’ favor, feeding Islamic State's propaganda message that it is defending Sunnis from a sectarian Shi'ite state that has neglected them.
The poorer the population becomes, the more it depends on militants who still have money.
"I think Daesh will benefit from this decision because it will draw more volunteers to resort to it for a salary to sustain their families," said Khalaf, the retired policeman.
"They have a lot of money and their members are living in luxury."
(Additional reporting by Ahmed Rasheed; Editing by Michael Georgy and Peter Graff)