There's been a lot of discussion about the inflationary effects of the GST increase since the Budget, but everyone is looking in the wrong direction. They're talking about consumers and interest rates and ignoring savers who are taking the biggest hit.

Labour is pointing to the combined effect of the GST hike, increased power and petrol prices from the Emissions Trading Scheme, and increased ACC levies as a sign the Government is increasing taxes and making consumers poorer. Even the Treasury is forecasting annual inflation will hit 5.9 per cent in 2011.

The Government responds it has structured the income tax cuts and various top-ups to ensure both middle and lower income earners are not disadvantaged.

The Government even argues real after tax incomes will rise between 0.5 per cent to 1 per cent once tax increases on property investors and foreign controlled companies are spread around. Interest rates are also unlikely to be affected directly by this inflation surge.

Reserve Bank Governor Alan Bollard has pointed to the clauses in the Policy Targets Agreement which allow him to look through the jump as a one-off increase, as long as it doesn't lead to any longer term increase in inflationary expectations.

But everyone is ignoring potentially the most damaging impact that will not be compensated for.

New Zealanders had $153 billion worth of savings in term deposits, debentures, bonds and savings accounts at the end of December, Reserve Bank figures show. Inflation erodes the purchasing power of these assets.

Over the next year expected inflation will reduce the real purchasing power of those savings by about $9 billion. Savers will not be compensated for this one-off erosion of this purchasing power.

The irony is they will actually be taxed extra for the privilege of earning interest on their savings. One of the great injustices of our tax system is the Government takes tax on the inflation component of interest earnings on savings.

Term deposit rates are unlikely to rise much to compensate for the boost in inflation, thanks to Bollard's move to look through the spike. In the coming year savers will receive interest returns far less than inflation and will have to pay tax on the interest they do receive.

Many economists have argued the Government should exempt tax on this inflation component of interest payments. Australia has just announced a 50 per cent tax break on the first A$1000 ($1243) of interest earnings from savings in term deposits.

New Zealand should do the same. That would go some way to encourage savings and compensate savers for this one-off permanent reduction in their wealth.

The final irony is one Budget aim was to encourage savings and reduce the incentives to invest in other assets where tax is not paid on capital gains, such as property. This inflation hit does just the opposite.

bernard.hickey@interest.co.nz