Calls for the state funding of political parties could damage Labour's links with trade unions, a left-wing think tank has warned.

A row between the centre-left Institute for Public Policy Research and Catalyst follows moves towards greater transparency in party funding and the call for a new system of tax relief to encourage smaller donations from individuals.

Catalyst are associated with "old Labour" - with an editorial board chaired by Lord Hattersley - while the IPPR, run by former Millbank assistant general secretary Matthew Taylor, is close to modernising government ministers.

The IPPR argued in its latest report, "Keeping it clean", that the current campaign expenditure "arms race" is forcing parties to seek large donations from wealthy individuals.

And since the government introduced the Political Parties, Elections and Referendums Act 2000, the influential think tank suggests that publishing details of donors and their gifts has prompted public cynicism about the role of wealthy people in the political process.

"Many donations, some relatively insubstantial, have been accompanied by media rows which discredit the motives of the donor and the party. These rows only serve to increase the unpopularity of parties and to discredit mainstream politics," said the report.

The IPPR backs a yearly spending cap of £20 million, falling over a period of five years to £15 million.

And the think tank also argues it is time to introduce a "donation cap" of £5000, a rate where the public could see that cash was not buying influence or access.

It is a move that would effectively break the Labour Party's historic funding link with the trade unions that created it.

"This would leave all parties with a shortfall on current income," the IPPR accepts.

The solution, said the report's authors, is to introduce a system of "tax relief plus" where donations of £50 might attract £50 from the state while a £100 donation could gain a £80 top-up.

"This would reward small donations more than larger donation," said the IPPR.

The report's authors say that the public could be won over to such a system by explicitly linking it with other reforms.

"In the context of spending caps and caps on donations, public support can be won for state funding for parties which encourage volunteer-intensive local campaigning rather than expenditure-intensive bought media campaigns."

To make the system work, communications methods should be "modernised", with the possible creation of a national telephone call-centre where voters "press 1 to speak to Conservative volunteers, 2 for Labour and so on".

But as the centre-left IPPR set out its proposals, rival think tank Catalyst branded the proposed reforms "off-target and ultimately anti-democratic".

The socialist think tank said there was a need for reform but warned that the IPPR's plan would sever traditional Labour links with the union movement.

"[The proposals] fail to get at the real problem of large private donations from individuals who may stand to benefit from government policy, and instead would have the effect of closing down a crucial channel through which millions of working people are able to participate collectively in the political process," said Martin McIvor, Catalyst director.

Professor Keith Ewing, an academic and expert who presented Labour's evidence to the Neill Committee inquiry into party funding, argued that donation caps "are ineffective in regulating real 'sleaze'" and would force a drastic restructuring of the Labour Party.

"Labour's opponents historically have taken the view that only individual membership of a political party should be permitted and that participation through an intermediary organisation [unions] should be prohibited," he said.

"But if this is a method of participation which citizens choose, it is unclear why it should be forbidden by the state, unless there is some compelling public interest which is undermined by the current arrangement."

Catalyst's comments were rejected by the IPPR.

The think tank's director, Matthew Taylor, described the left-wingers' position as "untenable".

"It is untenable to cap donations for corporations but allow trade union leaders at whim to write multi-million pound cheques," he said.

"Catalyst are effectively backing a cap on big business donations to the Tories but not trade union donations to Labour and that is undemocratic."

Taylor argues that trade union influence on Labour is a political rather than financial issue. "Their influence is through arguments not cash," he said.

The IPPR proposals would not alter the organisational link between the party and unions in areas such as votes and representation, he added.

But one of Labour biggest union affiliates, public sector union Unison, also warned that the IPPR proposals would "inevitably undermine the role of the trade unions as an important part of the Labour Party".

"Unions are members of the party and not just donors, but these plans would start to untie the party's organisation and links with the unions," said Unison's deputy general secretary, Keith Sonnet.

As the debate continued, the Conservatives said they are "not convinced" of the need for state funding.

In the last parliament Conservatives supported the recommendations of the Neill Committee that there should be tax relief on donations up to a specified limit - a move that failed to take off because of Labour opposition.

"At a time when there are failures in our public services, people want to see money spent on improving schools and hospitals, not going into the coffers of political parties," said party chairman Theresa May.

"The public will be suspicious that a Labour-supporting think tank has come up with these proposals - at a time when Labour's overdraft is rising and trades unions are becoming ever more militant."

Despite Tony Blair's comments that state funding could only be introduced on the basis of a cross-party consensus, the IPPR said its proposed system could be introduced without the support of the Conservatives.

"If a political party is implacably opposed to state funding it should not be forced to rely on it," said the report.

A voluntary system of state funding would allow parties to "opt in" to state funding in return for accepting the cap on donations. Alternatively "those who believe high value donations are more acceptable than state funding [could] persist with current practice".

As Labour struggles with its multi-million pound overdraft and cuts in union funding, party chairman Charles Clarke has indicated the government is contemplating a U-turn over tax relief for party donations.

"I don't think it [tax relief] is an unreasonable thing. We haven't gone down that course in the past but we are thinking about it. I am personally sympathetic to trying to find something in that area," Clarke said on Monday.

Meanwhile, the Liberal Democrats have called for more debate on the subject.

Mark Oaten, chair of the parliamentary Lib Dems, described the present system of funding as "a recipe for public suspicion" that had contributed to declining turnouts in national and local elections.

"Only by achieving cross-party consensus on issues such as the funding of political parties can we restore the public's confidence in the political process," he said.