He also called for higher pay for banks' non-executive directors and said the Government should prevent retail banks from dealing in derivatives.
Mr Taylor, who helped set the tone for banking reform at the Independent Commission on Banking (ICB), stopped short of advocating the division of Edinburgh-based RBS.
"There are a number of policy choices the Government can make, with RBS in particular," he said, depending on its aims.
"I would like to have a feeling that the Government recognises there are policy options and is thinking along those lines rather than saying 'our job is to get the business back into the public sector at some stage'."
He said the Parliamentary Commission on Banking that the Government should have completely nationalised the bank, which is 82% state-owned, and "used it as a vehicle for what they wanted to do".
Full nationalisation is still possible, he noted.
It was reported last year that business secretary Vince Cable wanted RBS split up and use it as a business bank. It was also reported that the Cabinet had discussed nationalising RBS.
Last week former Bank of England policy maker Adam Posen called for RBS to be divided to improve competition and make it easier to sell.
Mr Taylor, Barclays' chief executive from 1994 to 1998, also called for a shake-up of boards.
"It would be a good idea to have smaller bank boards with fewer directors and pay them better to get more work from them," he said.
RBS directors were paid a basic fee of £72,500 according to its annual report for 2011 and those at Lloyds Banking Group £65,000. RBS chairman Sir Philip Hampton received £750,000.
A key recommendation of the ICB's report in 2011 was the ring-fencing of retail banks from riskier investment banks.
The Parliamentary commission has since called for "electrification" of the fence with regulators given powers to split banks up if they try to circumvent the rules.
Mr Taylor told the commission that ring-fenced banks should be prevented from dealing in derivatives.