an idea just popped into my head while reading the OP:
@Lark - the problem you are describing here is on an ethical level of punishment, but let's be clear about the actual point of punishment - scaring the crap out of people. and for most people prison does a good job of that, except one group of people in particular - those who have actually being to prison, because let's face it - they go back a lot.
not only does it currently suck as far as any utopian dreams of rehabilitation, but it actually makes those who've being through it less afraid of going back.
now, i see the problem of people seen it as a form of "lighter punishments" - but what if we can actually use a hierarchy of environments to make the system better? basically have a leveling system of sorts where each you get a much harsher environment, so instead of going back to the old familiar prison experience you have gotten used too, you will have a whole new level to be terrified of and even better reasons to stay out of the prison system.