Wendy Alexander yesterday called for a Scottish Constitutional Commission to draw up plans over the next year for the Barnett funding formula to be replaced.

The controversial 29-year-old system for the Treasury granting money to Scotland would be replaced by significant new powers for Scotland to set levels for some taxes and to be assigned a share of other taxes set in London. There would be a smaller block grant based on a new assessment of need.

The Scottish Labour leader suggested welfare and road traffic law could be among more powers to be devolved.

Her speech at Edinburgh University was one of the most significant developments in the home rule debate in recent years. It represented a major challenge to Prime Minister Gordon Brown, Chancellor Alistair Darling and other Scottish Labour MPs at Westminster, where there has been resistance to revisiting the powers set out in the 1998 Scotland Act and where the implications could be complex.

There was a reminder to her party of what happened to Tory support in Scotland when it stood against constitutional change, and she argued that Labour had won support when it had been "the party of ideas on the constitution".

She said that unless it developed an alternative to independence, there was a risk people would assume that was their only choice.

Ms Alexander, one of the architects of devolution as adviser to Donald Dewar, admitted the tax powers Holyrood has are the wrong ones. She said developments had to be secured alongside the rest of the UK, adding: "The Union needs to be a comfortable home for all its members."

She said the Constitutional Commission had to be independent and expert-led, to develop "a more balanced home rule package", possibly including some powers being returned to Westminster.

The speech was overshadowed by the controversy swirling around Ms Alexander over financial donations to her leadership campaign. But if she survives, it marks new territory for Scottish Labour and prepares the ground for a cross-party agreement between unionist parties.

That is scheduled to be sealed next week, when Labour uses its debating time at Holyrood to table a motion that would endorse the Constitutional Commission.

With the support of Tories and LibDems, and therefore assured of a majority, this will make it clear that it is to look at developments for Scotland within the UK, meaning the SNP will not support it.

In another St Andrew's Day speech, Tory leader Annabel Goldie backed the idea of an independently-chaired commission, saying the future of home rule "lies in making devolution deliver, not in forced divorce".

LibDem leader Nicol Stephen wrote to party activists arguing that Scotland could learn from Spain about the way forward for home rule, and said that there should be a "gutsy" approach to further reform.

SNP leader Alex Salmond said the moves in unionist parties towards more powers were part of the growing support for a referendum.

The unionist parties' proposal of a Constitutional Commission would be a similar model to the Scottish Constitutional Convention which paved the way towards devolution in the early 1990s.

Two months into her leadership, Ms Alexander's speech put the future of Scotland in historical perspective, arguing Labour's founder, Keir Hardie, was among those demanding home rule within the United Kingdom before there was significant support for independence.

Ms Alexander admitted the SNP "was not unimportant" to the home rule cause, but stressed that its electoral success in May was based on a promise not to move to independence without a further vote.

She said support for nationalists since 1967 had represented a Scottish "cry of dissent from an increasingly centralised British state".

The speech argued devolution as it now existed was weakened because it was conceived as being forced on a reluctant Westminster government, rather than being negotiated.

It then focused on spending money, instead of considering how taxes could be levied. As a result, the tax allowing MSPs to vary basic rate income tax by 3p up or down was approved 10 years ago "at precisely the point at which many were realising elsewhere the need for a more sophisticated approach to taxation".

This was a speech that sought to move Labour away from scare stories about the break-up of Britain, making a more positive case for sharing resources, revenue and risks across the UK.

It will take time before Labour can reorient itself from its woes, but when it does, it should not underestimate the significance of the challenge Alexander set her Westminster comrades.

Plans for new powers