Tax Deflation: How to Protect Your Purchasing Power During Inflation

Have you ever received a salary increase only to find that you actually have less money to spend? Welcome to the 2022 phenomenon: uncontrolled inflation and its devastating consequences on your wallet. In Spain, it reached 6.8% in November, while Europe and the United States faced unprecedented interest rate hikes in decades. To counteract this, governments and central banks have implemented restrictive fiscal policies, with the most controversial being the deflation of IRPF. But what does it really mean, and how could it affect your investment strategies?

▶ Understanding Deflation: Beyond Economic Theory

For any investor, comparing financial performance over time is essential. However, inflation and deflation create a veil that distorts reality. Prices go up or down, masking whether your wealth has truly grown or simply appears to grow in nominal numbers.

What is a deflator? It is a statistical tool that adjusts economic values by removing the noise of price changes. Instead of comparing gross nominal figures, the deflator allows measuring only real volume variations. A base year is selected, and all other periods are compared relative to it, expressed as an index or percentage of change.

Let’s take a practical example: a country produces 10 million euros worth of goods in Year 1. In Year 2, the figure rises to 12 million. Without adjusting for inflation, it would seem like a 20% growth. But if prices increased by 10%, the reality is that the growth was only 10%. The latter is the real GDP, while the 12 million represents nominal GDP.

GDP deflation reveals the truth behind the numbers. When the central bank announces growth rates, are they talking about nominal or real GDP? This distinction is crucial for any investor trying to understand where their money really stands.

▶ IRPF Deflation: The Fiscal Measure Dividing Opinions

In Spain, the debate over deflating IRPF has made headlines for months. What exactly is it about?

IRPF is a direct and progressive tax that taxes the income of residents in Spain over a calendar year. Its structure works in brackets: the higher the income, the higher the tax rate. Here’s the problem: when your salary nominally increases due to inflation, you automatically move into a higher tax bracket, paying more taxes on what is essentially the same purchasing power.

Deflating IRPF means adjusting these brackets according to inflation, ensuring that a salary increase due to inflation does not translate into a higher tax burden. In other words, if you earn 1,000 euros more due to inflation but the cost of living also increased proportionally, you shouldn’t pay more taxes on that “illusory gain.”

How does it work elsewhere? The United States deflates its tax system annually, as do France and Nordic countries. Germany does so every two years. Spain, on the other hand, has not made this adjustment nationally since 2008. Some autonomous communities have announced adopting the measure, but the central government has yet to comment.

The reality is important: although it sounds like a big tax relief, the benefits for an average person amount to only a few hundred euros per year. So don’t expect a radical change in your purchasing power.

▶ The Dilemma: Beneficiaries vs. Critics

Proponents of deflation argue it’s a matter of fiscal justice. Taxpayers shouldn’t lose purchasing power just because prices rise. It helps families maintain their standard of living in high inflation scenarios.

Critics offer strong counterarguments:

1. Widening inequality: Due to the progressive structure of IRPF, tax benefits are concentrated among high incomes. Someone earning 200,000 euros benefits more than someone earning 20,000.

2. Risk of inflationary feedback: Greater purchasing power could increase demand for goods, which in turn would push prices higher. Exactly the opposite of what central banks aim for with higher interest rates.

3. Reduction in public revenue: Less tax collection means less money for education, healthcare, and essential public services.

▶ Investment Strategies in an Inflationary Context and Restrictive Policies

If IRPF deflation is effectively implemented, investors would have more disposable income. What to do with it? Inflation and high interest rates affect different assets in various ways.

Safe Assets: Commodities

Gold has historically been the money’s bodyguard in turbulent times. When inflation erodes the value of fiat currency, gold maintains or increases its value. Unlike government bonds (which are taxed in IRPF), gold does not generate interest but has long-term appreciation potential.

However, beware: in short and medium terms, gold prices can be extremely volatile. Only over the long term has it shown consistency in maintaining value.

Stock Market: Opportunities in Crisis

Inflation and high interest rates are traditionally enemies of the stock market. They reduce investors’ purchasing power and dramatically increase corporate borrowing costs. Result: lower profits and depressed stock prices. 2022 confirmed this: while energy companies posted record profits, the tech sector plummeted.

But here’s the interesting part: although volatile and risky, a recession also presents opportunities. When stock prices fall, investors with liquidity and a long-term horizon can buy assets at depressed prices. Historically, the market recovers and grows, even after major declines. Some sectors even thrive during crises: companies offering essential goods and services, or those covering basic needs.

Currencies: Volatility and High Risk

The forex market can be attractive during high inflation, as changes in interest rates and inflation affect exchange rates. High inflation typically depreciates the national currency, making foreign currencies appreciate in comparison.

However, forex is not for the faint-hearted. It is highly volatile and carries extremely high risk, especially without experience. Leverage amplifies both gains and losses. Small initial investments can turn into huge losses or gains overnight.

▶ Diversification: Your Best Ally

Inflation does not affect all assets equally. Some go up, others go down, some stay stable. The key is to diversify your portfolio to include a balanced mix:

• Traditional income-generating assets: stocks, real estate, commodities
• Defensive assets: treasury securities and government-backed bonds
• Other alternative assets according to your risk profile

This diversification reduces risk and allows your portfolio to perform well across different economic scenarios.

▶ Final Reflection: Will Deflation Really Change Your Investment?

If the Spanish government finally implements IRPF deflation, you might have a bit more cash available. What would happen then?

Increased availability for investing: Additional income could be directed toward profitable assets, boosting overall demand for investments.

Sector reorientation: If deflation includes incentives for specific sectors (clean energy, technology), you would see capital flows toward those areas.

Limited macroeconomic impact: The uncomfortable truth is that the average fiscal benefit is modest. Expecting deflation to completely revolutionize national investment levels is wishful thinking.

The important thing to remember: no investment is free of risks. Values fluctuate, markets surprise, inflation remains unpredictable. Deflation is just another political tool in governments’ arsenal facing the price crisis. Your job as an investor is to stay alert, diversify wisely, and not confuse temporary fiscal recovery with real financial security.