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Act Party leader David Seymour announced the policy at his party's annual conference on the weekend.
Eligible inmates would earn up to six weeks for every year of their term, depending on the types of courses completed. For example, a person sentenced to three years in prison could get up to 18 weeks deducted from their time in jail.
The policy would not apply to the worst violent or sexual offenders.
Prisoners with higher levels of educational attainment could earn similar reductions if they acted as mentors to help other prisoners learn.
Prime Minister Bill English said the policy "is something we can look at".
Last year Mr English attended a prizegiving ceremony at Rimutaka Prison, for inmates who had completed a literacy course run by the New Zealand Howard League for Penal Reform.
The league's programmes aim to get prisoners to a competent reading level, enabling them to read books to their children, take driver tests and have a better chance of finding work when they are released.
"It's quite moving to see people who have had long, difficult lives feel like they are achieving something. In some cases it's the first time they have been recognised for being able to read and write," Mr English said.
"The big that needs quite a bit of discussion is reducing sentences. The New Zealand public has a pretty fixed and firm view that criminals should be locked up for as long as possible. You would need a pretty broad consensus that it was a good thing."
That could be possible - Labour's Corrections spokesman Kelvin Davis said, at first look, he liked the Act policy.
"If we had come out and said that...we would have been mocked and ridiculed for this 'socialist soft on crime' thing.
"Without seeing any detail, there is merit in that [the policy]. But the rehabilitative programmes have got to improve before it happens...but it's great, we can build on it."
In October, the Government announced plans to cope with a booming prisoner population including a 1500-bed prison on the current Waikeria Prison site in Waikato.
Those changes will hit the Government's books by an extra $2.5 billion over about five years.
"We certainly would be focussing on these issues because we've had to make a substantial spend on new prison capacity. The numbers are still rising, there will probably be more required," Mr English said.
"And anything that is going to reduce, particularly the recycling of criminal offending is worth considering."