Tax Deflation: Why Investors Need to Understand This Tax Policy During Inflationary Times

The Current Context: Why Deflation Became the Word of the Year

2022 will be remembered in economic history as the year central banks declared war on inflation. With interest rates at historic highs in the United States and Europe, and a surge in prices not seen in decades, millions of citizens felt their money losing value day by day. In Spain, inflation reached 6.8% in November 2022, forcing governments and monetary authorities to make drastic decisions.

Amid this economic chaos, a term quickly gained prominence in political debate: the deflation of the IRPF. Left- and right-wing politicians began debating this measure as a possible solution to prevent taxpayers from losing purchasing power. But what exactly is deflation, and how does it affect your investments? Here’s an explanation.

Deflation: The Concept Every Investor Must Master

To understand deflation, you first need to grasp a fundamental problem in economics: comparing economic figures over time is more complicated than it seems.

Imagine a country’s GDP went from 10 million euros in year 1 to 12 million in year 2. At first glance, it would seem that the economy grew by 20%. But if prices increased by 10% during that period, the reality is very different. When we adjust for inflation (—that is, when we “deflate” )—we find that the real growth was only 10%, not 20%.

This mathematical adjustment that removes inflation noise and reveals only genuine growth is called deflation. Economists use a “deflator”—a figure that expresses the change in prices over a period—to compare nominal GDP (12 million) with real GDP (11 million). The result: a clear view of whether an economy, a company, or a family has truly improved or if it was just an illusion caused by inflation.

What Does Deflating the IRPF Mean in Practice?

The deflation of the IRPF is a tax measure designed to protect taxpayers from a perverse effect: when wages rise along with inflation, taxpayers end up paying more taxes even if their purchasing power has not improved.

The real problem:

Suppose your salary increases by 5% because the company recognizes inflation. Sounds good, right? But if inflation was 6%, you actually lost purchasing power. To make matters worse, the Spanish IRPF is progressive: the higher the income, the higher the tax percentage. So, even if you earn more nominally, you could end up in a higher tax bracket, paying a larger percentage of taxes on a salary that is lower in real terms.

Deflation solves this by adjusting IRPF brackets according to the CPI (Consumer Price Index). In this way, if your salary rises due to inflation and not real productivity, you shouldn’t change tax brackets or pay a higher tax burden.

What is IRPF?

The Personal Income Tax (IRPF) is the most important direct tax in the Spanish tax system. It taxes the income of residents in Spain and is progressive: the higher the income, the higher the tax percentage. It is precisely this progressivity that the deflation aims to address.

International Experience: Who Already Deflates and Who Does Not

In the United States, IRPF deflation occurs automatically each year. The same happens in France and Nordic countries. Germany adjusts every two years. These countries understood long ago that ignoring inflation in tax brackets is equivalent to a disguised tax increase.

In Spain, the situation is different. The last national adjustment occurred in 2008. Since then, despite previous inflation cycles, there has been no systematic deflation. Recently, some autonomous communities have announced they will implement this measure on their own, but the central government has not done so broadly yet. The limitation is that IRPF has both state and regional components, so deflating only at the regional level would have limited effects.

Arguments For and Against: The Debate Dividing Economists

Proponents of deflation argue that:

• It protects the purchasing power of working families
• It prevents a de facto increase in the tax burden caused by inflation
• It stimulates consumption, which could help the economy recover

Critics point out that:

• It mainly benefits higher incomes, deepening inequality (because in a progressive system, the taxes saved are greater the higher the income)
• It reduces state revenue, limiting its capacity to fund education, healthcare, and other essential services
• Restoring purchasing power through lower taxes could increase demand, pushing prices up and creating an inflationary cycle
• The benefit for an average family is modest: just a few hundred euros annually

How Deflation Impacts Your Investment Strategies

If deflation were implemented, taxpayers would have more disposable income, which could theoretically increase demand for investments. But this is only half the story. Here’s how different assets behave in scenarios of high inflation, high interest rates, and potentially partial deflation:

Gold and Commodities: The Traditional Safe Haven

Gold has historically been the preferred asset when confidence in currencies erodes. During periods of high inflation, as money loses value, gold tends to maintain or even increase its value. It is not tied to any national economy, acting as a hedge.

The dilemma: although gold has risen consistently over the long term, in the short and medium term, it is extremely volatile. In 2022, we saw sharp fluctuations. It is a protection asset, not a growth asset.

Stocks: The Inflation Minefield

Inflation and high interest rates are generally enemies of stocks. They reduce consumers’ purchasing power and dramatically increase borrowing costs for companies. The result: lower corporate profits and falling stock prices, exactly what we saw in 2022.

But here’s the opportunity: not all stocks behave the same. Energy companies, for example, posted record profits while the tech sector plummeted. Some companies producing essential goods or serving inelastic demand resist inflation better.

Paradoxically, during a recession, if you have liquidity, buying cheap stocks can be a winning long-term strategy. Markets have always recovered historically, even after catastrophic declines.

Currencies (Forex): Volatility as Opportunity and Risk

The currency market reacts sensitively to changes in inflation and interest rates. A currency of a country with high inflation typically depreciates against others. This can create opportunities: buying currencies of countries with weak currencies can be profitable when those countries control inflation.

But forex is also the most volatile and risky market, especially due to leverage. It is designed for experienced investors with extremely high risk tolerance.

Bonds and Fixed Income: The Interest Rate Dilemma

Government-backed bonds are theoretically safe, but in times of inflation and high inflation, their yields can erode. That said, some inflation-linked bonds offer protection. However, taxes on accrued interest remain an important factor to consider in your real return calculation.

What Does All This Mean for Your Portfolio?

The deflation of IRPF is a tax measure that could free up some cash for taxpayers. But here’s the uncomfortable truth: the benefits are modest for most, barely equivalent to savings of a few hundred euros per year.

More important than waiting for deflation is understanding this: in times of inflation and economic uncertainty, diversification is your best ally. Combine defensive assets (gold, bonds) with growth assets (selective stocks, real estate), adjust according to your time horizon and risk tolerance, and remember that no investment is free of risks.

True protection against inflation does not come from reduced taxes but from wisely investing in assets that have historically preserved and generated wealth over the long term. Deflation is just a small tool in your arsenal; the overall strategy is what truly matters.