Tony Blair's chief fundraiser today urged Labour to "cut the umbilical cord" and accept curbs on trade union donations.
Lord Levy called for union leaders to lose their controversial discretion to hand over significant sums to parties.
He also backed a cap on large gifts from individuals, and said there should be more public funding for parties.
The peer, who raised money for Mr Blair while he was Labour leader and prime minister, was giving evidence to an inquiry by the Committee for Standards in Public Life.
The party has been heavily reliant on gifts from major bodies such as Unite over recent years.
But Lord Levy said he wished to see a formula in future where unions merely acted as a "conduit" for individual donations.
"A union is made up of its membership," he said. "If the member decides he wants to support a political party, it may be the Labour Party, then when they pay their dues to the union they mark down £50 to the Labour Party, £50 to the Liberal Democrat party.
"The union will then merely act as a collecting agent ...
"They could only pass over the totality of the individual donations of their union members to the party of their choice.
"They could not just decide, 'we want to give X amount to, in most circumstances, the Labour Party'.
"They would only be a conduit."
Asked whether that would damage unions' traditions and heritage, Lord Levy said he was "sure" most members would opt to give money to Labour.
"If we are going to move forward and if we are unprepared to cut the umbilical cord on every issue, where do you go to?" he added.
New party funding arrangements should be put in place before the next general election in 2015, he said.
"The longer one puts it off and doesn't bite the bullet, I believe the more problematic it becomes," he added.
Talks between the three main parties on reforming funding have been deadlocked for more than three years.
Union donations have been among the main sticking points, with Labour resisting Tory demands for the traditional affiliation to be broken and members freed to decide which party gets their money.
There is also dispute over whether unions should be covered by a proposed £50,000 cap on gifts.
It is hoped the committee's inquiry can get the negotiations back on track, and stabilise the finances of political organisations after a string of scandals.
Lord Levy, who was embroiled in the cash-for-honours row but never faced any criminal action, said he thought a limit on the size of individual donations was necessary to prevent ongoing speculation about wealthy people buying influence.
"There is only one way you are going to stop these question marks, and there are question marks," he said. "That is if there can no longer be large donations to political parties and if there is a cap put on donations to political parties."
The peer suggested parties should be financed with a mix of public money and smaller donations.
"I don't believe the public would squeal if more money came - and if you look at this in the totality of the budget you are talking about a really really tiny point zero zero percentage - if more money was to be put into political parties in order to fund them," he added.
Lord Sainsbury of Turville, who has donated more than £10 million to Labour over the past decade, also called for more state funding and a cap on donations.
He warned that the main parties had proved "completely incapable" of agreeing a deal and the deadlock was damaging the public perception of politics.
The peer said the need to attend to large donors put senior figures in a very difficult position.
"I think it exposes senior politicians to having policy discussions with particular interest groups knowing that that particular interest group may have been providing a large amount of the funding capacity of the party," he told the committee.
"I personally think it is very clear. Unless we really rethink this and have at least 85% of money for political party funding from the state - there should still be some room for small donations but they should be capped at £500 or £1,000 - you will not solve this."
The former science minister said the total cost to the taxpayer of funding parties would be "£50 million rather than £250 million".
"The political parties have shown themselves to be completely incapable of having serious negotiations on this particular issue and unless a body like yourselves does something about it we will go on with this very unsatisfactory situation," he said.Reuse content