Deflacting the IRPF: a guide to understanding how to protect your purchasing power against inflation

What Does Deflating Really Mean in Economic Contexts?

When we hear that “we need to deflate taxes,” many investors wonder what this entails for their portfolios. Essentially, deflating is a technical process that adjusts economic magnitudes by removing the effect of inflation, allowing for the comparison of real values across different periods without price changes distorting the analysis.

A deflator functions as a normalization tool. It compares a reference year with a base year, revealing whether real economic growth comes from increased production or simply higher prices. For example, if a country’s gross domestic product (GDP) increased from 10 million euros to 12 million between two consecutive years, the apparent growth is 20%. But if prices rose by 10% during that period, the true economic growth was only about 10%. The difference between nominal GDP (12 million) and real GDP (11 million) is precisely what the deflator helps identify.

Economists constantly use this technique to analyze economic variables over time: from company performance to wage and sales trends. Without deflating, any historical comparison would be contaminated by price fluctuations that mask the underlying economic reality.

Deflating Personal Income Tax (IRPF): A Fiscal Measure to Address Inflation Crisis

During 2022, economies like Spain experienced unprecedented inflation in decades. With the consumer price index rising to 6.8% in November of that year, governments were forced to implement more restrictive fiscal policies: interest rate hikes, reductions in public spending, and tax increases.

It is in this context that the proposal to deflate the (Personal Income Tax (IRPF)) arises. This measure aims to adjust progressive tax brackets according to inflation, preventing taxpayers whose nominal earnings increase from being taxed at higher marginal rates without actually improving their purchasing power.

How does IRPF deflation work

IRPF is a progressive and direct tax on the annual income of resident individuals. Its tax brackets are designed so that higher income results in a higher tax percentage. The problem arises when inflation pushes wages upward nominally: an employee receiving a 3% salary increase during a 6% inflation period has lost real purchasing power but would be taxed in a higher IRPF bracket, further reducing their buying capacity.

Deflating IRPF involves readjusting these brackets based on the CPI (Consumer Price Index) or wage growth. This way, taxpayers do not experience an additional fiscal burden solely due to inflation. It is not technically a tax cut but a maintenance of the tax balance in the face of price changes.

In countries like the United States, France, and Nordic nations, this adjustment is made automatically every year. Germany does it biennially. Spain, on the other hand, had not performed this adjustment at the national level since 2008, although some autonomous communities announced plans to implement it in fiscal years after 2022.

Impact on Investments: Advantages and Limitations

Arguments in favor of deflation

Proponents argue that it protects the purchasing power of families in inflationary scenarios, making it easier to cover daily expenses without eroding their buying capacity. Additionally, higher disposable income could stimulate demand for investments, especially income-generating assets like stocks or real estate, whose after-tax returns improve significantly.

Criticisms and counterpoints

Critics warn that the measure creates inequality: due to the progressive nature of IRPF, higher-income taxpayers benefit more fiscally. They also point out a macroeconomic paradox: while protecting purchasing power stimulates demand and pushes prices upward, curbing that demand is precisely the goal of restrictive policies to control inflation.

There is also concern about public funding: reducing tax revenues could compromise investment in essential services like education and healthcare. The economic effects of a full IRPF deflation for an average person amount to a few hundred euros annually, so its macroeconomic impact is limited.

Investment Strategies in the Face of Inflation and Fiscal Restraints

When high inflation converges with restrictive fiscal policies, returns across different asset classes behave disparately. Here are practical considerations for various types of investments:

Commodities and Gold

Historically, gold acts as a safe haven during economic crises. When inflation erodes the value of money and interest rates rise, gold can maintain or increase its value because it is not tied to any specific economy or currency. Unlike government bonds that generate interest (susceptible to IRPF taxation), gold offers long-term appreciation potential. However, in short- and medium-term horizons, it can be highly volatile, although the long-term historical trend shows sustained growth.

Stocks and Equity Markets

Inflation and high interest rates generally harm the stock market: they reduce investors’ purchasing power and significantly increase corporate financing costs for operations and expansion, depressing earnings and stock prices. 2022 was a vivid example, with the tech sector collapsing while energy companies reached record profits.

However, the stock market offers opportunities during recessions for long-term investors with available liquidity. Price drops allow buying assets at significant discounts. Historically, markets have recovered and grown over the long term after sharp declines. Defensive companies that meet basic needs or have resilient demand during uncertainty tend to withstand better than sectors more sensitive to economic conditions.

Forex Market (forex)

Exchange rates are affected by inflation differentials and interest rate increases. High inflation tends to depreciate the national currency as its purchasing power diminishes, making foreign currencies attractive for purchase, which can appreciate in relative terms. But forex is a highly volatile and risky market, especially for inexperienced investors. Exchange rates fluctuate in response to economic conditions, political events, and market sentiment. Additionally, inherent leverage allows for disproportionate gains and losses with small initial investments.

Diversification as a Safeguard

The most prudent strategy in contexts of inflation and restrictive policies is to diversify the portfolio by combining assets that behave differently depending on market conditions: defensive stocks, government-backed bonds, commodities, and alternative assets. This reduces idiosyncratic risk and improves exposure to different economic scenarios.

Conclusion: Beyond IRPF

Deflating IRPF could free up disposable income, leading to increased demand for investments, particularly income-generating assets. It could also redirect flows toward specific sectors if the tax structure includes targeted incentives (such as green energy, technology, for example).

However, it is crucial to remember that no investment is risk-free and that values fluctuate continuously. The individual benefits of IRPF deflation are modest (a few hundred euros), so considering it as a decisive factor in country investment decisions would overestimate its importance. The true impact on investment strategies will depend more on the overall portfolio composition, time horizon, and the investor’s risk tolerance than on peripheral tax adjustments.