IRPF Deflation: How to Protect Your Purchasing Power During Inflation

Inflation in 2022 reached unprecedented levels in Europe and the United States, hitting 6.8% in Spain in November. When the prices of goods and services rise broadly, your purchasing power decreases even if your salary remains the same. A fiscal tool designed to curb this effect is the deflation of IRPF, a mechanism that many countries apply but that Spain still does not implement systematically at the national level. What does this mean for your wallet and your investments?

Understanding deflation: From economic concept to practice

Deflation is an adjustment used by economists to compare real economic values by removing the impact of price changes. Imagine a country produced goods worth 10 million euros in year one, and in year two production rose to 12 million. Without considering inflation, you would say it grew by 20%, but if prices also increased by 10%, the real growth was only 10%. This adjustment is what deflates economic data to reveal the truth.

The concept is frequently applied to GDP, business sales, and wages to compare real performance over time. When we normalize these values considering inflation, we get what is known as real GDP ( as opposed to nominal GDP which does not account for inflation).

What is deflation applied to IRPF?

The personal income tax (IRPF) in Spain is a progressive tax that levies residents’ annual income. Its structure includes tax brackets: the higher the income, the higher the applicable tax rate.

Deflating IRPF means adjusting these tax brackets considering inflation and nominal salary increases. The goal is to avoid what is known as “fiscal inflation”: when your salary rises due to inflation (not due to real productivity), you end up paying more taxes on that nominal increase, losing even more purchasing power.

Practical example: An employee earning 30,000 euros was taxed in a specific bracket. The following year, they receive a raise to 33,000 euros, but those 3,000 euros extra are just inflation. Without IRPF deflation, they move into a higher tax bracket, paying more taxes on money that nominally increased but did not actually make them richer.

International context: Who deflates and who does not

The United States, France, and Nordic countries deflate IRPF annually. Germany does so every two years. In Spain, there has been no such annual adjustment at the national level since 2008, although some autonomous communities have announced their adoption.

This difference is significant: periodic deflation better protects taxpayers’ purchasing power in economies with persistent inflation.

Impact on investment strategies: What you need to know

IRPF deflation would leave more money in investors’ pockets. This can have several effects:

Increased investment capacity: With reduced taxes, demand for financial assets would increase, especially those that generate post-tax returns such as stocks and real estate.

Sector redistribution: If deflation includes specific incentives (green energy, technology), investment would concentrate in those segments.

Limited market pressure: Despite these potential benefits, the average savings from deflation are only a few hundred euros annually for an average person, so its macro impact on national investment volumes would be limited.

Investment strategies amid inflation and high interest rates

In scenarios of high inflation and restrictive fiscal policies (interest rate hikes, public spending cuts), different assets behave differently:

Gold and commodities: Gold has historically been a safe haven in times of uncertainty. When the value of money falls, gold tends to maintain or increase its value. However, it is highly volatile in short and medium terms, though long-term it has steadily increased in price.

Stocks: Inflation and high interest rates negatively pressure the stock market, reducing corporate profits and lowering share prices. However, not all companies suffer equally: energy and basic needs producers can thrive, while technology and sensitive industries may decline. In recessionary contexts with high volatility, there is opportunity for patient investors with a long-term horizon, as markets historically recover and grow even after severe drops.

Currencies (Forex): High inflation causes depreciation of national currencies, making foreign currencies attractive to buy that could appreciate. However, forex is highly volatile, high risk, and subject to leverage, where small investments can generate or lose large sums. Only recommended for experienced investors.

Bonds and government securities: Offer low risk backed by issuing governments, designed to provide returns adjusted to inflation.

Diversification: Your best defense

Inflation affects different assets unequally. A diversified portfolio combining stocks, commodities, real estate, and bonds reduces risk and takes advantage of different market conditions. Also consider the fiscal impact on your investments: gains will be taxed under IRPF, affecting your net return.

What really matters: The advantages and criticisms of IRPF deflation

Pros: Protects workers’ purchasing power facing inflation, easing their expenses when prices rise. Theoretically, it increases consumption and investment.

Cons: The measure disproportionately favors high incomes due to the progressive nature of IRPF. Maintaining purchasing power can increase demand and push prices upward, complicating inflation control. Additionally, it reduces state tax revenues, making it harder to fund public services like education and healthcare.

Final considerations

IRPF deflation is a fiscal policy tool with moderate but real impacts on investment capacity. Its absence in Spain since 2008 at the national level means that during inflationary periods like 2022, taxpayers lose additional purchasing power due to taxation on nominal increases.

For investors, the recommendation is to diversify according to time horizon: long-term stocks during recessions, commodities and currencies (moderately) for inflation hedging, and bonds for stability. Regardless of deflation, no investment is risk-free, and all assets fluctuate. Assess your risk profile, objectives, and timeframe before investing.