Deflactar in practice: How fiscal policy impacts your investment decisions

The Current Context: Inflation and Fiscal Policy Decisions

During 2022, European and U.S. governments and central banks implemented unprecedented restrictive measures to combat the highest inflation in decades. In this scenario of rising prices and loss of purchasing power, a key question arises for taxpayers: how to protect our real income from these adverse economic effects?

One of the measures that has gained prominence in fiscal debate is the practice of deflating, especially applied to Personal Income Tax. In Spain, with inflation around 6.8% as of November 2022, various regional governments have considered this fiscal strategy. However, the concept of deflating goes beyond taxes: it is a fundamental tool to understand how our investments and assets truly evolve over time.

What Does Deflating Really Mean?

Deflating is an adjustment made by economists to compare economic values by removing the impact of inflation or deflation. Imagine your company produced goods worth 10 million euros in year one. The next year, the figure reached 12 million. At first glance, this would seem like a 20% growth. But if prices increased by 10% during that period, the real growth was only about 10%.

This adjustment is what is known as deflating: normalizing data considering changes in prices to obtain the true performance. The result is what economists call “real” values, as opposed to “nominal” values that do not account for inflation.

To deflate, experts select a base year against which all other periods are compared. In the analysis of the CPI (Consumer Price Index), the percentage change relative to the base year represents the inflation rate. The GDP deflator, for example, helps measure price changes by comparing nominal gross domestic product with real GDP across periods.

This concept is not only applicable to national GDP but also to business sales, workers’ wages, or investment returns. It is the tool that allows investors and analysts to understand whether they are truly gaining or losing purchasing power.

Deflating the IRPF: A Fiscal Measure to Protect Income

In the Spanish tax system, the Personal Income Tax is the fundamental pillar of fiscal collection. It is a direct and progressive tax that levies the income of Spanish residents each calendar year.

Deflating the IRPF means adjusting the tax brackets so that taxpayers do not lose purchasing power when their nominal incomes increase. When a worker receives a salary increase, without an adjustment in tax brackets, they may end up paying more taxes simply due to inflation, even if their real purchasing power has not improved. This phenomenon is called “fiscal drag” or “bracket creep” in English.

How does deflating work in practice?

If a taxpayer earns 30,000 euros and is in the 24% bracket, but inflation is 5%, their nominal income rises to 31,500 euros. Without deflating, they would be taxed at the next bracket (say, 26%). With deflating the IRPF, the brackets are adjusted according to inflation, allowing their tax burden to remain proportional to their real purchasing power.

This measure is not a direct tax cut but a technical adjustment that is only visible in the annual income tax return. In the United States, France, and Nordic countries, deflating the IRPF is an annual practice. Germany implements it every two years. Spain, at the national level, has not made this adjustment since 2008, although some autonomous communities have announced their adoption for upcoming fiscal years.

Debate on Advantages and Limitations of This Policy

Proponents of deflating the IRPF argue that it is essential to maintain families’ purchasing power in inflationary contexts, allowing them to meet expenses without eroding their real income.

Conversely, critics point out that this measure can generate inequalities. Since the IRPF is progressive, higher incomes receive greater fiscal benefits in absolute terms. Additionally, they argue that increasing purchasing power can boost aggregate demand, putting upward pressure on prices and counteracting efforts by central banks to control inflation.

Another relevant aspect: reducing fiscal revenue can affect funding for public services such as education and healthcare, limiting the government’s capacity to invest in infrastructure and social welfare.

How Deflating Affects Your Investment Strategies

If IRPF deflation is implemented, investors would have additional disposable income, potentially increasing demand for financial assets. Investment decisions in inflationary and restrictive fiscal policy contexts require a differentiated strategy depending on the type of asset.

Gold and commodities

Gold has historically served as a safe haven during periods of high inflation. When money loses value, gold tends to maintain or increase its value because it is not tied to any specific economy. With high interest rates, investors seek alternatives that do not generate income taxed by the IRPF (such as government bonds), and gold offers the potential for long-term appreciation.

However, in short- and medium-term horizons, gold can be very volatile. Although it has historically appreciated over the long term, daily fluctuations can be significant.

Stocks and equities

High inflation and high interest rates typically harm the stock market. They reduce investors’ purchasing power and make credit more expensive for companies, impacting earnings and share prices. 2022 was a clear example: tech sector companies collapsed, while energy producers recorded record profits.

But the stock market has important nuances. Companies producing goods or services with inelastic demand (basic needs, energy) may resist better. For long-term investors with available capital, recessions can be buying opportunities at depressed prices, as the market has historically recovered and grown even after major declines.

Currency Market (Forex)

The foreign exchange market is sensitive to variations in inflation and interest rates. High inflation often depreciates the local currency, creating opportunities to buy foreign currencies that could appreciate. However, forex is highly volatile and risky. Exchange rates fluctuate due to multiple economic, political, and market sentiment factors. Additionally, leverage allows for significant gains or losses with small initial investments.

Practical Recommendations for Investing in Inflation

When facing an inflationary scenario and restrictive policies, diversification is essential. Consider a combination that includes:

• Assets with proven historical profitability: stocks, real estate, and commodities that tend to increase in value during inflation
• Defensive assets: treasury securities and government-backed bonds designed for inflation-adjusted returns
• Geographical and sectoral diversification: different assets respond differently to market conditions

It is crucial to consider tax impact. Investment gains are taxed in the IRPF, so the fiscal adjustment represented by deflating can improve your net investment returns, especially in income-generating assets like dividend stocks or real estate.

Final Reflection: Deflating as a Tool for Wealth Protection

Deflating, both as an economic concept and as a concrete fiscal measure, represents a crucial tool to protect your assets in inflationary contexts. Understanding how to deflate your investments allows you to assess whether you are truly making money or just seeing nominal numbers without real value.

While the immediate economic benefits of deflating the IRPF for an average taxpayer might amount to just a few hundred euros annually, its long-term cumulative impact is significant. More importantly, understanding how to apply the concept of deflating to your own investment decisions, selecting assets that safeguard your purchasing power against inflation and monetary policy changes, is essential.