Understanding the Deflated Value: Key to Protect Your Purchasing Power During Inflation

The year 2022 will be marked in economic history by a phenomenon not seen in decades: the combination of record inflation and unprecedented interest rate hikes in Europe and the United States. Consumers felt it immediately in their wallets, with the Consumer Price Index (CPI) soaring to worrying levels. In Spain, this indicator reached 6.8% as of November 2022, significantly eroding the purchasing power of families and businesses.

In response to this situation, governments and central banks have implemented restrictive tax measures to contain the inflationary spiral. The most well-known is the increase in interest rates, which limits borrowing and cools demand. But there is another less visible but equally important strategy: adjusting tax brackets according to inflation, known as deflating. This mechanism aims to prevent taxpayers from losing purchasing power simply because their nominal incomes increase.

▶ What Is Really Deflating?

To understand what deflated value means, we first need to understand why this concept is necessary. Inflation and deflation mask the actual economic performance. When comparing economic figures over time, price changes distort reality: did the economy really grow or did prices just go up?

A deflator is precisely that: a mathematical tool that expresses price changes over a given period. It works like a “deflater” that removes the noise of inflation, leaving only real volume changes. It is frequently used to analyze key economic variables such as Gross Domestic Product (GDP), business sales, or workers’ wages.

A practical example: Suppose a country produced €10 million worth of goods and services in year 1. In year 2, GDP reached €12 million. At first glance, this seems like a 20% growth. But if prices increased by 10% during that period, the reality is different. When applying the deflator and normalizing for inflation, the real growth was only 10%. This adjusted figure is called real GDP, while the initial €12 million represents nominal GDP. The deflated value of GDP in year 2 would then be €11 million, not €12.

This process is fundamental because it allows comparison across different periods by eliminating price distortions. Economists always select a base year as a reference and calculate percentage changes relative to it.

▶ Deflating the Personal Income Tax (IRPF): The Measure That Protects Your Purchasing Power

In Spain, politicians have debated intensely about a specific application of this concept: deflating the Personal Income Tax (IRPF). What does deflated value mean in this context? It refers to adjusting progressive tax brackets so that a nominal salary increase does not result in losing purchasing power by moving into a higher tax bracket.

The IRPF is a direct tax that levies on the annual income of Spanish residents. Its progressive nature means that the higher the income, the higher the tax rate. Without deflating, if your salary rises by 5% due to inflation, you could move into a higher tax bracket and lose net purchasing power.

The goal of deflating the IRPF is to adjust these brackets considering the CPI or wage growth. It is not formally a tax cut but an invisible mechanism that only becomes apparent in the tax return.

How is it applied internationally? In the United States, it is deflated annually. France and Nordic countries do the same. Germany does it every two years. In Spain, at the national level, it has not been applied since 2008, although various autonomous communities have announced their adoption. The problem: IRPF has both national and regional components, so applying it only regionally limits its actual effects.

▶ The Debate: Advantages vs. Disadvantages

Proponents argue that deflating the IRPF is essential to ensure that families do not lose purchasing power during inflationary periods, helping them maintain their standard of living.

Critics counter with two main arguments:

First, it creates inequality. Due to the progressivity of the IRPF, high incomes receive greater absolute tax benefits than low incomes, even if the percentage is the same.

Second, economically it is contradictory. A loss of purchasing power dampens demand and helps control inflation. Restoring it through deflating can increase demand and push prices upward, worsening the problem. Additionally, lower tax revenues could compromise funding for essential public services such as education and healthcare.

▶ Investment Strategies in Inflationary Environments

When inflation is high and interest rates are restrictive, the investment landscape changes dramatically. Deflating the IRPF could leave investors with more disposable income, boosting demand for assets. Here are the main options:

Commodities: The Traditional Safe Haven

Gold has historically been a defensive investment during times of economic uncertainty. When the value of money erodes due to inflation, gold tends to preserve or increase its value, without being tied to any specific economy or currency. High interest rates make it even more attractive, as government bonds generate IRPF on the interest.

However, it’s important to be realistic: there are no guarantees. Over the long term, gold has increased in value historically, but in the short and medium term, it can be extremely volatile.

Stocks: Calculated Risk

Inflation and high interest rates generally exert negative pressure on stock markets. Investors lose purchasing power, and companies see their financing costs rise, reducing profits and stock prices.

2022 demonstrated this clearly: energy sectors reached historic profit highs while technology stocks plummeted. But within the chaos, opportunities exist. Companies that meet basic needs or have high demand during uncertainty can thrive. More importantly: recessions cause price drops that are historic opportunities for long-term investors. The stock market has always recovered and grown over the long term, even after major crashes.

Forex: Currency Volatility

The foreign exchange market reacts strongly to changes in inflation and interest rates. High inflation typically depreciates the national currency, making foreign currencies attractive to buy, as they could appreciate. But beware: forex is highly volatile and high risk. Leverage allows for huge gains but also devastating losses with small initial capital. Exchange rates fluctuate unpredictably due to economic, political factors, and market sentiment.

Diversification: The Fundamental Strategy

The true defense is diversification. Inflation affects different assets disparately. A balanced portfolio combining stocks, bonds, commodities, and other assets can withstand various macroeconomic scenarios and significantly reduce risk.

It is also crucial to consider low-risk assets backed by governments, such as Treasury securities and bonds, designed specifically to provide returns that adjust to inflation.

▶ The Real Impact of Deflating on Your Investments

If widely implemented, deflating the IRPF would have several potential effects on the investment market:

Increased capital availability: Taxpayers with extra income might seek investments that generate additional returns, increasing demand especially for stocks and real estate where after-tax returns would improve.

Sectoral reallocation: If deflating included incentives for certain sectors (green energy, technology, etc.), investors would reallocate funds toward those areas, causing significant capital reallocation.

However, be realistic: the average savings from deflating the IRPF for an ordinary taxpayer amount to just a few hundred euros annually. Expecting this measure to radically transform national investment levels is quite unlikely.

▶ Final Reflection

Understanding what deflated value means is more than an academic exercise: it’s about understanding how your purchasing power erodes and is protected in inflationary economies. Deflating the IRPF is an invisible but important mechanism that aims to maintain tax fairness when prices rise.

For investors, the message is clear: in times of inflation and restrictive interest rates, smart diversification, understanding market dynamics, and a long-term horizon are more important than ever. There is no risk-free investment, but there are smart strategies to navigate volatility. The key lies in understanding these economic mechanisms to make informed decisions.