Lord Sutherland: It's time to face the university challenge

His nightmare scenario was: "annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery". If only the gap was that small! But the principle is just the same.

Universities know this; the government knows this; the unions know this, and the students associations know this.

On the whole so far, "officialdom" is pretty tight-lipped, but the warnings and counter-blasts are beginning to surface. We do not have time for a phoney war, and real public discussion in Scotland has to take place.

In England, Vince Cable put his toe in the water to urge a graduate tax as the answer to financial shortfall, but assiduous leaking of the possible outcome of the inquiry into university funding by Lord Browne tells its own story. The suggestions are that he will propose the raising of the cap on student fees. This is still speculative, albeit deliberate, spin, and of course it applies only to England and Wales, not to Scotland.

What then of Scotland?

The government has distanced itself from student fees. But of course so did the Lib Dems in England at one time.

The real debate which we have not had during the years of plenty is about what kind of university system Scotland needs and wants. If we had written down the answer to that 20 years ago, the description would look very different to what we have today. This debate has to be held, but unfortunately decisions about funding for the next three years cannot await the outcome. However, the debate must begin, not least so that the strategy for implementing cuts looks like a strategy towards the future rather than a series of crude salami slices of the past. It will not be easy to think forward about redirecting the ship when a chief preoccupation will be to keep the engine running, but when was strategic management ever easy?

One thing is for sure, we cannot fund the status quo on current cash flows.

There are few sources for plugging the financial gap. The first, to which universities and colleges are addressing their attention is self-help. This means efficiencies yet to be found, setting spending priorities, increasing earnings, and matching each of these to a coherent strategy for healthy survival.Clearly they must think laterally - additional overseas students paying full fees is a natural direction to take. It has its dangers, but I know of several UK engineering departments which would have collapsed in the 1980s and 1990s without a good flow of undergraduates from Hong Kong and Singapore. They provided both viable class sizes and income.

A rather different option is to consider collaborations: these most obviously include, where appropriate, joint teaching programmes (as for example in the joint postgraduate physics programme in central Scotland). However, less showy but at least as important is the sharing of facilities and back office functions. Instead of outsourcing administrative tasks across the world, sharing, for example, payroll functions across the city or across Scotland is worth more than a cursory thought. And of course development work with alumni and donors is now well above the horizon. These will all help at various rates of progress. But they will not of themselves deal with the expenditure gaps anticipated for the next three to five years.

An additional flow of funds will be necessary to avoid generally slipping down world performance tables, and to match the boost already given to English universities by current and future top-up fees.

There are very few alternative external sources. Business and industry, with a few noble exceptions, did not give when they could afford it. For the next few years, even if they wanted to, many will be themselves struggling.

This leaves two main alternatives: government support through some form of dedicated tax, or contributions to the cost of education in the form of fees.

Graduate tax looks as if it might be fairer and more sustainable, as the main option being floated is to link it to future earnings of graduates. Those who can pay will.

Some problems, however, have to be faced. The first, which should not be underestimated, is that the Treasury is not noted for its willingness to ring-fence payments of this sort or, bluntly, to keep its fingers out of the pie.

The second is that it will not apply to European Union students, of whom in 2008-09 there were 13,500 at Scottish Universities.

The third is that those who graduate and then emigrate, having had all the benefits, will not realistically be pursued for the tax, and indeed it might increase the incentives for some of our brightest and best-educated to do just that.The fourth is that there will be an ambiguity about the position of those who "drop out" in mid or late course (with earned level four qualifications already on their CV).

Equally, part-time students who graduate may reasonably feel that they are being disproportionately penalised, having made fewer demands on university resources.

Further, it could be argued that the graduates in question will already be paying more tax by virtue of earning higher salaries.

A general graduate tax leans in the opposite direction to encouraging alumni to support their alma mater. On top of which, if I pay a graduate tax why should I be expected to contribute to the costs of "my" university?

Finally, this system will not deliver the immediate cash flow urgently required over the next three years. Borrowing money from the banks against future cash flows might be good news for the banks, but it will increase costs to universities.

It may, however, seem "fairer" and more universal. It will certainly seem so to European Union students, who will in all probability never pay any UK taxes.

Fees have their drawbacks as well as advantages. The downside includes the risk that less-advantaged students will be deterred. However, the evidence so far from England is that this is not the case, albeit that it is early days. There is also the fact that the costs of some courses are much higher (as are the potential rewards) than others.

Clearly if the fees route is to be contemplated then safeguards and modifications will have to be built in.

The first and by far the most important of these is to incorporate into any enabling legislation an agreed percentage of the fees income to be spent on means-tested student support. The private universities in the US are good practical examples of how to do this.

Another move within possible legislation is to make any fees paid tax-deductible, either to sponsoring companies or to supportive relatives. Indeed, giving a tax credit for these fees to be cashed against earnings in future is an alternative strategy worth examining.

Informally, universities should be encouraged to use fee-charging powers flexibly, between courses as well as between universities, to reflect actual costs. This would argue for no cap being imposed, for the current evidence is that all will charge up to the full cap allowance.

These alternatives will seem daunting, and they are. However, on the one hand, the most successful university system in the world, in the US, has many of its best universities charging full-cost fees. One consequence is a publicly funded system which is smaller and less costly than it would otherwise be. Now there's a prospect to contemplate.

• Lord Sutherland of Houndwood is former principal and vice-chancellor of Edinburgh University, a former convener of the Committee of Higher Education Principals and a former vice-chancellor at London University.