News Analysis: Cash-strapped Labour is paying the price of Tony Blair's promise to clean up politics

When Tony Blair and the 31 other members of Labour's ruling body, the National Executive Committee (NEC), gather at the party's Millbank headquarters this morning, the growing strains on Labour's finances will be very apparent. The hot buffet lunch traditionally provided at NEC meetings, which often run into the afternoon, has been replaced by sandwiches, just one of the cost-cutting measures hitting the party at all levels.

A gloomy report to the NEC admits that Labour faces the "biggest financial crisis" in its 102-year history. What is the explanation for this paradox, only a year after the party won a second landslide election victory?

Support for all parties is draining away; they have become dangerously out of fashion. Mr Blair once dreamt publicly of creating a "mass membership party" with one million foot-soldiers. In the heady days of 1997, Labour membership rose to 405,000, but has now slumped to 280,000. Although Labour insists the figure is stable, members are resigning in protest at the Government's policies.

Mr Blair did achieve another of his original aims as party leader: to wean Labour off its financial dependence on the trade unions. They used to provide 90 per cent of the party's funds. Today, Labour says the largest slice of its income (40 per cent) comes from members and small donations; 30 per cent from the unions; 20 per cent from gifts of more than £5,000; and 10 per cent from commercial activity, including sponsorship and the annual party conference.

Labour's latest accounts show that trade union affiliation fees, once the bedrock of the party's finances, brought in only £6.3m of its £31.8m income in 2000. Donations accounted for £15.9m and membership fees £3.2m.

As the big donations from wealthy individuals rolled in, Labour was happy enough. But the party became a victim of its own promises in opposition to "clean up" politics. In 2000, the Government passed a law ending the secrecy which meant we never knew who was giving money to the Conservatives during their 18 years in power; in future, all donations of £5,000 or more would be revealed to the public.

As some Millbank officials had feared, Labour made a rod for its own back. The punishment started this year, with a stream of allegations that Labour donors received favours from the Government, including the steel magnate Lakshmi Mittal and Paul Drayson, chief executive of Powerject Pharmaceuticals, which won a £32m contract to supply smallpox vaccines.

Not surprisingly, the bad headlines have scared off other potential backers.

Individual donations were already on the wane because they always peak at general elections. A committee set up by Labour to vet future donations – after the row over the £100,000 gift from Express newspaper and soft-porn publisher Richard Desmond – now finds its main problem is reeling in any big fish at all.

To make matters worse, Labour felt the squeeze from both sides. The unions, feeling bruised and neglected by Mr Blair since last year's election, began to reduce their financial contributions.

The GMB, the RMT transport union and the Communication Workers' Union have cut their funding to Labour by an estimated £3m over the next five years.

So now the party is having to ask the unions to think again. "We may come round, but we want a signal first," said one union source. Mr Blair, against his gut instincts, will probably be prepared to smooth the unions' ruffled feathers, but he may be less keen to offer concessions on policy. This was easier in Labour's first term, which saw the introduction of a minimum wage, new recognition rights in the workplace and the working time directive.

But there is little in the pipeline to appease the unions, who are incensed by Mr Blair's stance on labour market reform and his "cuddling up" to right-wing European leaders such as Italy's Silvio Berlusconi. A review of the recognition law passed in 1999 is unlikely to bring the unions much joy, since ministers are under strong pressure from business not to enhance union power.

In the short term, Labour has no option but to turn to its one stable source of finance – its members.

Today's NEC meeting is expected to approve big increases in their annual subscriptions – from £7 to £12 for the unemployed and pensioners and from £18.50 to £24 for others. (Some 60 per cent of members currently pay the cheaper "unwaged" rate, a figure viewed with suspicion at Millbank, which plans stricter checks).

"We have to bite the bullet on subscriptions," one Labour source said yesterday. "We have three lines on a graph showing our income – individuals, unions and members – and they are all pointing downwards. The only one under our control is the members, so all we can do is put up the fees."

The NEC will be told that Labour is £6m in the red and has other debts estimated at £2m. It has also taken out a £5m mortgage on a smaller headquarters in Westminster, into which it will move when it leaves Millbank Tower next month. Most of the 100 HQ staff will be based in North Shields to save money.

The Co-operative Bank, which funds the party's overdraft, wants further savings and departmental heads have been told to work out the impact of cutting their budgets by either five or 20 per cent. Some £200,000 has been earmarked for redundancies, even though Millbank's staffing levels have halved since last year's election.

The jobs of some of the 130 Labour staff in the regions are also under threat, and there are fears that the party will not be able to mount a strong enough campaign at next May's elections to the Scottish Parliament and Welsh Assembly. Millbank is expected to ask the Scottish and Welsh parties to take much more of the strain than they did in 1999, when the first elections to the two devolved bodies were held.

The gathering financial clouds have prompted calls for the Government to bring in state funding for all political parties. Mr Blair was won over in principle during this year's "cash-for-access" rows, but wants the cover of all-party backing. Mr Blair's official spokesman said yesterday: "The Prime Minister believes there is clearly a debate to be had, but he is not persuaded of the arguments in the absence of consensus."

The Tories, however, have no intention of letting Labour off the hook or helping the Liberal Democrats, the barrier to a Tory revival in many constituencies. The case for state funding is now being examined by the Electoral Commission and the Institute for Public Policy Research think-tank. These reviews may produce a formula under which the £20m spending limit for each party at election campaigns is further reduced and a cap is put on individual donations, which might be matched by the state or given tax relief.

However, such a package would put a question mark over Labour's historic link with its union founders, just at a time when the party needs them – in the short term, at least.

Ironically, New Labour figures used to talk with enthusiasm about a divorce between the party and the unions. In his first term, Mr Blair reached a fairly stable settlement with them, with neither side wanting a separation.

Now it is the unions who are considering a parting of the ways: they are voting with their wallets and electing a new generation of left-wing leaders, such as Derek Simpson, the new joint general secretary of Amicus.

Whatever the strains in the relationship, Labour and the unions will not be heading for the divorce courts yet. The unions have nowhere else to go, and Labour needs their money as much as ever.

Labour's big donors

LORD SAINSBURY

A member of a supermarket dynasty, Lord Sainsbury of Turville was the biggest donor to any political party in the first three months of the year. His latest gift of £2m to Labour brought the total of his contributions to the party to £9m.

CHRISTOPHER ONDAATJE

The retired financier and publisher was shown to be one of Labour's biggest donors in January 2001, when his £2m contribution was revealed. Once a Tory backer, he is also a prodigious philanthropist. He gave £1.5m to the Royal Geographical Society last year.

LORD HAMLYN

The late publisher gave Labour £2m before the 2001 election. There was no obligation to reveal the gift because it pre-dated a cut-off point for disclosing donations in February 2001. But Lord Hamlyn stepped forward to save embarrassment.

RICHARD DESMOND

The publisher of Express newspapers, gave £100,000 to Labour last January. The gift, made through his company Northern & Shell, came shortly after the Government cleared his takeover of the Express. Both sides have denied any impropriety.