Understanding deflation: key to protecting your profitability against inflation and tax changes

When we talk about deflating in economics, we refer to a fundamental mechanism for correctly comparing financial performance over time, eliminating the noise caused by price fluctuations. In 2022, this concept gained particular relevance in Spain, where inflation reached 6.8% in November, forcing governments and investors to rethink their strategies in an unprecedented interest rate hike scenario.

The Investor’s Compass: Why Deflating Matters in Your Portfolio

The fundamental challenge in finance is determining whether we are truly gaining or losing value over time. A salary that increases by 5% while inflation rises by 6% represents a real loss of purchasing power, even if the nominal numbers suggest otherwise.

A deflator is precisely that tool that allows separating real gains from the effect of prices. It compares a base period with another period, expressed as an index or percentage change, to “clean” an economic figure from inflation distortion. When a value is deflated, its real measure is obtained.

Let’s take an example: if a country produces goods and services worth 10 million euros in year 1, and in year 2 that production reaches 12 million, we might think it grew by 20%. But if prices increased by 10% during that period, the true growth is only about 10%. This inflation-adjusted figure is known as real GDP, while the initial 12 million corresponds to nominal GDP. The GDP deflator, therefore, reveals the hidden reality behind nominal numbers.

This analysis is not academic: governments, companies, and investors apply it continuously to evaluate wages, sales, stock returns, and all important economic variables.

Deflating the IRPF: How Governments Try to Preserve Purchasing Power

In Spain, one of the most active fiscal debates in 2022 was precisely deflating the Personal Income Tax (IRPF), a measure aimed at preventing taxpayers from losing purchasing power solely due to nominal salary increases.

IRPF is a direct and progressive tax that taxes the income of Spanish residents. Its tiered structure means that, without deflation, a worker receiving a 3% salary increase could move to a higher tax bracket and end up with less purchasing power than before, because they pay taxes at a higher rate on a nominally larger income.

Deflating IRPF means adjusting these brackets according to inflation or wage increases, ensuring that taxpayers do not suffer involuntary fiscal erosion. This practice is standard in many developed countries: the United States applies it annually, as do France and Nordic countries; Germany every two years. However, Spain has not made this adjustment at the national level since 2008, although several autonomous communities have announced their adoption.

Important: the effects are only noticeable in the tax return, and even if autonomous communities implement it, the actual impact will be limited because IRPF has both regional and national components.

The Dilemma: Benefits versus Consequences of This Fiscal Policy

Proponents argue that deflating IRPF protects families from losing purchasing power, helping them maintain their consumption levels in high-price environments.

Critics counter that it creates inequality because, due to IRPF’s progressivity, the greatest fiscal benefits go to higher incomes. Additionally, reducing taxes can decrease public revenues allocated to education and healthcare. From a macroeconomic perspective, some economists argue that restoring purchasing power could boost demand and, with it, prices, working against the goal of controlling inflation.

Investment Strategies in the Face of High Inflation and Rising Interest Rates

When inflation hits and central banks raise interest rates to curb it, the environment for investors becomes challenging. However, proven approaches exist to navigate these turbulent waters.

Gold and Commodities: Traditional Safe Haven

Gold has historically retained value when money depreciates. During periods of high inflation and elevated rates, investors turn to gold as an alternative that prevents erosion of purchasing power. Although it has systematically risen over the long term, in short- and medium-term horizons, it can be extremely volatile. Other precious metals and commodities may also benefit, especially if demand remains robust.

Stocks: Opportunities in Volatility

Inflation and high rates generally pressure stock markets, reducing corporate profits and increasing financing costs. 2022 demonstrated this: sectors like technology plummeted while energy companies hit record profitability.

However, not all sectors suffer equally. Companies that meet basic needs or benefit from economic uncertainty can thrive. For long-term investors with available liquidity, recessions offer opportunities: when prices fall, buying cheap stocks can generate substantial gains after the recovery, which has historically followed.

Currencies: Volatility and High Risk

In forex, inflation in a country usually depreciates its currency. This can offer attractive buying opportunities in foreign currencies that appreciate. However, the currency market is highly risky, especially for beginners. Leverage amplifies gains but also potential losses, turning small investments into large money movements within hours.

Diversification: The Strongest Defense

Regardless of the chosen strategy, diversifying the portfolio among assets that behave differently under inflation is essential. Combinations of stocks, treasury bonds, real estate, and commodities reduce systemic risk and improve results across different scenarios.

The Real Impact of Deflating IRPF on Your Investments

If IRPF were deflated, taxpayers would have higher net incomes, potentially increasing demand for investments. Income-generating assets — stocks, real estate — could be especially benefited because their after-tax returns would be higher.

Similarly, if the tax reduction includes incentives for specific sectors like green energy or technology, capital allocation toward those areas would likely intensify.

However, it is crucial to note: for an average person, the savings from deflating IRPF are modest, just a few hundred euros annually. Expecting this measure to dramatically transform national investment levels would be naive; its true value is marginal but accumulative over time.

Final Reflection

Deflating is more than a technical term: it is a principle that helps investors and governments see beyond nominal numbers. When interest rates rise, inflation spirals out of control, and taxes threaten purchasing power, understanding how to deflate your financial analyses allows you to make decisions based on economic realities, not accounting illusions. Investment strategies in these challenging contexts require both technical knowledge and flexibility to adapt to a constantly changing market.