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Wales should have the power to vary income tax levels to become more accountable for its spending, an inquiry has said.

The Holtham Commission into how Wales is funded said part of a Treasury block grant should be replaced with revenue raised from Welsh taxpayers.

The commission wants ministers to be able to vary the basic and higher rates of income tax by up to 3p in the pound.

The Welsh Assembly Government and political parties welcome the report.

Currently, the assembly government's annual budget of nearly £16bn is calculated via the Barnett formula, which is based on spending in England on areas including health and education.

A previous report from the commission last year said Wales was losing out under the population-based formula and would be better off if funding was based on need.

Tax allowances

The second report suggests half of each income tax band is devolved, with the ability to vary each rate separately.

But the power over tax allowances and thresholds should, the independent report says, remain with the UK government.

Delivering the second report to the assembly government, commission chairman Gerald Holtham said its watchwords were "fairness and accountability".

"We think the present funding regime is defective in both those two areas," said the Aberdare-born economist.

"At a time when public spending is under unprecedented pressure, it would be regrettable if the UK government persisted with an unfair, outdated and arbitrary system for allocating funding to the devolved nations.

"This year, over £50bn of public money will be handed out to the devolved administrations without even the most cursory attempt to see if what is provided is in line with what is needed."

Total budget

The report argues that the assembly government should have power over half of each tax band - 10p of the basic rate, 20p of the existing higher rate and 25p of the new higher rate of tax.

The total amount raised via income tax in Wales in 2007/08 is estimated to be £5.2bn, while the assembly government's total budget this year is £15.7bn.

The assembly government has welcomed the report.

Business and Budget Minister Jane Hutt said: "Building on the analysis in the commission's previous publications, the report takes forward the arguments for aligning funding with needs and also provides a thorough analysis of the scope for devolution of additional fiscal powers for Wales.

"I welcome both the report's demonstration of how a needs-based funding regime could be made to work in practice and also its reassertion of the case for the introduction of a floor in the Barnett formula for Wales, pending further reform.

Welsh Liberal Democrat leader Kirsty Williams said the report provided "a good basis for the Westminster government to build on" in reforming the way the devolved institutions are financed.

Plaid Cymru's finance spokesman Chris Franks said: "I would urge the UK government to realise the importance of the issues raised in the report and respond positively, allowing this Welsh government to continue its work for the good of our communities."

Welsh Conservative group leader Nick Bourne AM said: "Both the Conservative group in the assembly and the Welsh Conservative Party accept that there is a need to replace the Barnett formula with a needs-based system.

"Our group will now consider a wider review of taxation options and will be studying the findings of the report in great detail, which provides definite food for thought."

The commission was set up two years ago as part of the coalition deal between Labour and Plaid Cymru.

It previously said Wales was losing out on £300m a year because of the formula.