The universities and science minister commented on Scotland's system during a fringe event at the Conservative Party conference in Birmingham last night.
Mr Willetts - whose science and research portfolio is UK-wide but whose remit over teaching funding covers England only - was responding to an audience question about the perceived unfairness of students from Scotland facing no fees but those from England being charged up to ?9,000.
"In the short run I can see the appeal of not having any fees in Scotland," Mr Willetts replied. "In the long run the question is how do you sustain the right levels of investment to ensure our universities remain world class?"
Under the Scottish budget, the no-fee system "either means they have to cut other activities, or they are unable properly to finance their universities in the future, or they have to put up taxes in Scotland," he continued. "If you want world-class universities, the money's got to get to them somehow."
Mr Willetts added: "And there is, I know, in some Scottish universities an anxiety as to whether, without fees, they are going to remain properly financed.
"There will come a point when the students will say: 'How well equipped are the labs? Where are the internationally mobile academics?'...And that is a challenge for Scotland."
He asked: "In the long run, who is going to have the better universities that students wish to go to?"
Mr Willetts was speaking at an event hosted by Dods and Politics榴莲视频, titled "Funding our universities, is business the answer?"
The minister also discussed the importance of better graduate employment data for the student loans system in England.
Mr Willetts said he welcomed the fact that the Office for National Statistics' Labour Force Survey will now ask people where they went to university and what subject they studied.
He added that the Social Mobility Sector Transparency Board, a body on social mobility statistics he chairs with deputy prime minister Nick Clegg, is "working...on how we can get further employment outcomes data".
Mr Willetts continued: "I would dearly love better employment outcome data for courses. It would help solve lots of problems, including RAB charges [the proportion of a loan that will not be repaid and will be written off by the government], graduate repayment thresholds, graduate repayment performance. We are working on that."