The UK has suffered the biggest contraction in its workforce since the 1980s, costing the public finances at least £16bn a year in lost tax receipts, according to a study.

Hundreds of thousands of people have quit the labour market since the pandemic and never returned, undermining the strength of the economy and leaving the government out of pocket, according to the Institute for Employment Studies.

The “participation crisis” is shown by the 1.5 percentage-point fall in the share of people aged 16 and over either in work or looking for work since the eve of the pandemic – equivalent to about 800,000 fewer people in the labour force and representing twice the contraction seen after the 2008 financial crisis.

Had the UK maintained the same proportion of the population in a job as there were before the pandemic, the economy would be £25bn larger and thousands more workers would be paying tax, equating to £16bn in extra tax receipts.

The report, based on the findings of a two-year commission on the future of employment support, and funded by abrdn Financial Fairness Trust, shows that several distinct groups of workers have swelled the ranks of people who are no longer looking for work.

Many people who were out of work before the pandemic have remained jobless, when they would previously have retrained and found work again. Meanwhile, there is a growing band of young people who have never worked, often staying out of the jobs market after leaving school or college because they suffer from ill health.

Tony Wilson, the institute’s director, said the UK was an outlier in the developed world where workers had returned to the labour market since the pandemic, often in even larger numbers than before the crisis.

“This situation has parallels with the one Britain found itself in during the 1980s, when deindustrialisation pushed many people to the margins,” he said.

The closure of coalmines, steelworks and large sections of the UK’s manufacturing industry 40 years ago left many towns and cities coping with mass unemployment and damage to local economies.

Much of the blame for the post-pandemic increase could be pinned on the last government and its employment reforms, which introduced strict conditions on people of working age, preventing them from receiving support and unemployment benefits, Wilson said.

“A strict conditionality regime is pushing people away from finding work. It is so draconian, people won’t engage in it.

“The new rules were introduced without any thought for the consequences,” Wilson added. “That was always going to be the reaction, and we are living with the consequences today.”

The government plans to overhaul the employment support service and local jobcentres in line with recommendations in the report.

The employment minister, Alison McGovern, who is speaking at the launch of the report on Wednesday, is expected to say that the state needs to offer encouragement and a helping hand to those out of work and fewer sanctions.

The report found that:

• The UK is one of the only countries in the developed world to have seen employment fall post-pandemic: slipping from having the eighth-highest employment rate in the world to 15th.

• The reduction can be blamed on fewer people entering work in recent years rather than more people leaving it, with 90% of the growth in “economic inactivity” due to more people off work for at least four years or who have never worked at all.

• The solution to the crisis could include reforming employment support to guarantee help for those who need it; ending the ‘compliance culture’ in jobcentres; and creating new Labour Market Partnerships to meet local priorities and join up delivery.

It said: “This ‘participation crisis’ is in stark contrast to the rest of the developed world, where employment is growing strongly and often setting new records – up by on average 1.3 percentage points across the OECD [Organization for Economic Cooperation and Development] group of developed nations.”

A spokesperson for the department of work and pensions said: “Spiralling inactivity and millions of people being denied the support and opportunities they need is holding the country back and stifling the economy.

“Growth is our number mission, and we’re going to deliver the change the country is crying out for by overhauling jobcentres and giving power to local areas to tackle inactivity, so more people can find full and fulfilling work.”