In a memo to the prime minister seen by the Times, the lord chancellor raises the option of reducing the use of prison sentencing for persistent but low grade offenders as well as removing the option of prison for low-level shoplifters.
Lord Falconer will head the newly formed Ministry of Justice which is formally launched tomorrow after being announced by the government as a new division of the Home Office earlier this year.
It is understood that Mr Blair, who famously promised to be "tough on crime, tough on the causes of crime", does not wish to lower his tough stance in his last few weeks in office.
Commenting on the report, a spokeswoman for the Department of Constitutional Affairs said: "Lord Falconer and the prime minister do not disagree."
She added that people must wait until tomorrow for a policy announcement from the new Ministry of Justice.
Prison population figures reached high levels at the end of last year, putting pressure on the home secretary John Reid to make temporary places available. But it is reported that these are beginning to fill and that the overall population is only a few short of the maximum.
Mr Reid wrote to magistrates reminding them of the community sentencing that can be used instead of prison terms in an effort to bring the population down.
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