Labour's fightback on welfare has begun. But merely to state that is to shout the size of the potential political catastrophe facing the party. Before Iain Duncan Smith, welfare was seen as Labour's territory. Now the question is: how should Labour respond to the Conservatives' agenda?

A double-barrelled counter-attack is crucial. How do we make sure the term "work pays" forms an effective policy, rather than a slogan? And what is the alternative to the government's strategy of yet more people being pushed on to means-tested assistance?

There are three major issues with the "make work pay" strategy. First, the tax credit system ensures that single mothers with children benefit hugely, but it doesn't benefit young men in the same way. The sums may show they can be better off in work, but only for a few pounds of extra income. This is not enough of an incentive to be worth "getting out of bed for".

Second, the government's current shortage of money might not be solved by increased growth. Let us suppose that at the next election voters see a 1% growth rate as realistic. In that scenario, welfare will have to be cut further if there is going to be any balancing of the books in the medium term. The existing tax credit bill is not sustainable.

Third, tax credits have given rise to a huge dependency not only among claimants but also among employers. This "wage subsidy" has grown to more than £26bn annually. And tax credits for women with children have almost obliterated the difference in levels of take-home pay between the highly skilled and the unskilled.

Huge swaths of the electorate cannot now make themselves better off by gaining qualifications or working longer. Only the chancellor can do that by changing tax credit rates. Such circumstances do not encourage the effort and entrepreneurial spirit required to generate economic growth.

Employers deliberately structure their jobs so employees can gain the maximum tax-credit supplement. Hence the extraordinary rise of part-time employment. Lots of people want part-time jobs, of course, but others now have no choice other than to take them, thanks to the distortions that tax credits create in the labour market.

Spelling out what we mean by making work pay must start from the fact that most of our voters earn less than £13,000 a year. And instead of reacting to every government press release, we have to set out soon our own strategy – which cannot be yet more tax credits.

Our alternative could fit the politics of budget cuts. The welfare budget has to be cut, yet the demand for welfare will grow. An ageing population, for instance – drawing pensions longer, needing long-term care and greater national health service resources – will see to that. But how can Labour persuade taxpayers to foot a higher bill?

Here the insurance principle comes centre stage, but only if politicians are prepared to treat taxpayers as grownups and sovereign. There is no mileage in thinking voters will gladly provide extra tax money if politicians can get their sticky fingers on it.

A series of insurance mutuals should be set up to cover existing benefits, like unemployment, but also emerging needs, like long-term care. The new insurance mutuals, to which everyone would contribute, would have to be run at arm's length from government, like the Bank of England, to prevent political raids on the funds. But this reform opens up the exciting prospect of providing universal services that are not run by the state or the private sector. The budget crisis could hopefully push Labour into a radical rethink along these lines.