The cost of jailing petty criminals should be charged to their home town to help cut the growing prison population, a report has recommended.
Cash held by Whitehall to cover custody costs should be devolved and the money spent on improving services, such as drug and alcohol dependency programmes, to help prevent repeat offending, the Institute for Public Policy Research said.
Local authorities should then be billed for the full cost of a prison bed to deter them from putting low-level offenders in jail, according to the think tank.
Jonathan Clifton, associate director for Public Services at IPPR, said: "Our court system is clogged-up, our prisons are overflowing and we have the highest re-offending rate in Western Europe. Reform is desperately needed to reduce offending.
"We need to free up cash that is frozen in the prison system, and give it to local areas to invest in tackling the social problems that drive re-offending such as lack of qualifications, mental health problems and homelessness."
An "extraordinary" amount of money is spent on prison places for low-level criminals in England and Wales despite the jail terms often failing to rehabilitate offenders, cut crime or protect victims, the Prisons and Prevention: Giving local areas the power to reduce offending report found.
But councils do not have the cash or incentives to focus on bolstering local services that could help reduce the nearly 90,000 strong prison population, it said.
Handing over custody funding totalling around £400m to local authorities then charging them for every local offender sentenced to less than 24 months would act as an incentive to improve crime prevention, the report said.
It also recommends increased use of non-custodial sentences, such as community supervision, unpaid work, curfews, banning orders and restorative justice programmes.
The IPPR points to the success of youth justice schemes in the United States where funding was devolved and bills for prison costs introduced. In Ohio, the number of young people incarcerated fell from more than 2,600 in 1992 when the programme was introduced, to less than 510 in 2013, it said.
A Ministry of Justice spokesman said: "Our prison system needs reform. Almost half of prisoners commit another crime within 12 months of release.
"We want prisons to be places of hard work and rigorous education. It's only through better rehabilitation that we will reduce re-offending, cut crime and improve public safety.
"We welcome ideas on improving our prison system and will consider this report carefully."