The Queen's shilling is no sovereign remedy for a world-class sector

Britain is a world leader in higher education, second only to America. Our universities are magnets for the world, attracting 400,000 overseas students annually.

You cannot, alas, say the same for British industry, our defence forces or our National Health Service. Higher education's annual revenue is £25.4 billion - much greater than those of the aircraft and space industries, pharmaceuticals and advertising. Universities are some of our greatest assets, so the message to the government is clear: handle with care.

Of course universities cannot be exempt from the government's austerity drive: already cuts are being made, staff laid off, less popular faculties scrapped and plans for new buildings put on hold. Higher education's 50-year expansion has shuddered to a halt, and it will not be resumed in the foreseeable future.

Even in the good old days, no government has ever given the universities the funding they deserve or need, and it is therefore now all the more important to protect and secure their pre-eminence - and the key to this is tuition fees. Under the present system, students do not pay those fees while at university, but receive some grants and loans that they repay when they can afford to.

The significance of tuition fees was made clear in a graph published in this magazine on 12 August, which shows that as fee income in the UK has risen, state support has fallen.

In the 1980s, I introduced two of the paving stones - per capita funding and student loans - that would lead to universities becoming less dependent on the state. In 1999 the Labour government, to its great credit, added the third - the introduction of student tuition fees. We are now awaiting Lord Browne of Madingley's report, which is widely expected to recommend an increase in the level of fees, provided that some of the extra income is diverted to student bursaries.

The government is in a quandary over this report. First, any increase in fees will lead to a direct increase in public expenditure because of the way in which the student loans scheme is financed. Second, there is a Liberal Democrat preference to abolish fees altogether. But without this extra money, British universities will fall down the international league tables as foreign universities, particularly in East Asia, embark on ambitious and expensive programmes to improve the quality of their teaching and research.

Fees have not deterred students; there have been rising and record levels of applications. Fees have also brought home to students the cost of their courses, leading them for the first time to demand better value for their money.

The government could do two things. One would be to make changes to the financing of the student loans scheme to reduce significantly the impact on the Exchequer. In addition, given its need to save money, it could decide to freeze the per capita grant for the future so that the proportion of the income of universities from the state declines in real terms, while its fee income increases. That is a good deal for the Treasury.

The alternative that is now mooted is some form of graduate tax or levy - a system that no other country has introduced and that the US would certainly reject. Such a tax is a poll tax on knowledge, and it would have had Iain Macleod - who as Chancellor of the Exchequer stopped VAT being imposed on books - turning in his grave. Lord Adonis has revealed that in 2001-02 the Labour government gave in-depth consideration to a graduate tax, only to discover that "it can't be done - unless you repeat the poll tax and try to make the unworkable work, inviting a catastrophe".

Each British university, over the next 10 years, should be seeking ways to become less dependent on the state, because if you take the Queen's shilling, the Queen takes an interest in how it is spent. In contrast, raising money through fees, research, philanthropy and alumni gives greater freedom.

A tax collected by the government and then allocated to universities would increase the power of the state, as well as undermine universities' freedom when each institution was obliged to bid for a share. How much to Oxford and Cambridge, and how much to Huddersfield and Greenwich? How does that fit into David Cameron's vision of a Big Society with independent, free-standing local bodies making their own decisions as to what they can do to enrich our society?