Cannabis and ecstasy should be sold in licensed shops, with the possession and use of all illegal drugs should be decriminalised, an inquiry by a group of cross-party peers has found.
A system for testing the safety of new drugs should be introduced with low-risk substances, which could be called "Class D" sold with labels detailing their risks, like cigarette packaging, members of the all-party parliamentary group for drug policy reform said.
While the supply of the most dangerous substances should remain banned, users caught with a small quantity of any drug should not be penalised, the Inquiry found.
The controversial proposals are likely to irk the Prime Minister who recently rejected calls by MPs to set up a royal commission to consider the decriminalisation of illegal drugs.
A panel of nine Conservative, Liberal Democrat, Labour and Crossbench peers from the all-party group conducted a parliamentary inquiry into new psychoactive substances.
Presenting the Inquiry findings, chair Baroness Meacher, who is also a chair of an NHS trust, said: "The Misuse of Drugs Act is counter-productive in attempting to reduce drug addiction and other drug harms to young people."
Baroness Meacher told The Times that it would be "daft" for Class D drugs not to include substances like ecstasy and low potency cannabis. "One of the benefits of well-regulated, low-harm highs is that young people might switch to them from alcohol."
The Act, which has been in force for 40 years, is in desperate need of reform, the group said.
The remaining sections of the act in use are causing "serious risks to the many young people who are determined to experiment with drugs", the group said.
The Act has forced thousands of young people into unemployment, homelessness and broken relationships, it added.
In support of decriminalising the use of all drugs, the report alluded to the model in Portugal, where the numbers of young addicts has fallen under decriminalisation.
And the proposals for regulating low-risk drugs echo those planned for New Zealand.
The group said: "Some young people will always want to experiment and they are at real risk if they can only buy the less harmful drugs from the same dealers who are trying to push the most harmful ones.
"The illegal dealers also have a clear incentive to adulterate their product to increase their profits."
The group said strict regulatory controls could be introduced with an enhanced role for Trading Standards Services in the UK.
"Under these controls suppliers would, as is planned in New Zealand, be limited to certain outlets and required to label their product with a clear description of its contents, its risks and the maximum advisable dose," the group said.
The licensed supplier would also be responsible for assuring that the product causes an "agreed level of limited harm".
Prevention programmes should also be promoted much more widely within schools and the community, the group said.
It also recommended that that a minimum of £1.5 million be made available for a targeted pilot of Club Drug Clinics in ten major hot spots across the UK with a duty to train front line accident and emergency and general practitioner staff.
The panel also said politics should be taken out of decisions on the classification of drugs, as the issues involve scientific judgments and are too sensitive for politicians.
The group took evidence from 31 experts and organisations including the Association of Chief Police Officers (Acpo) and the Advisory Council on the Misuse of Drugs.
As well as Baroness Meacher, the inquiry was undertaken by Baroness Stern, Lord Cobbold, Baroness Hamwee, Lord Howarth of Newport, Lord Low, Lord Mancroft, Lord Norton and Lord Rea.
The wider all-party group has a membership of 83 MPs and peers and includes former Director General of MI5, Baroness Manningham Buller.
David Cameron ruled out a royal commission to consider the decriminalisation and legalisation of illegal drugs on the grounds that the government's approach is working.
The influential home affairs select committee said there was a case for a fundamental review of all UK drug policy "now, more than ever".
But Cameron said drug use was coming down and added: "I don't support decriminalisation. We have a policy which actually is working in Britain."