Investment strategies in the face of CPI deflation and restrictive tax policies

How to Protect Your Wealth During Inflation

The inflation characterizing the current economic landscape presents one of the most pressing challenges for investors. When central banks implement credit restriction policies and raise interest rates, families face a gradual erosion of their purchasing power. In this context, understanding concepts like CPI deflation becomes essential for making informed financial decisions.

What is Deflating? The Fundamental Concept for Comparing Economic Variables

To measure the true economic performance of a region or investment over time, analysts use an adjustment mechanism known as deflation. This process allows separating real changes in volume or output from fluctuations caused by variations in the prices of goods and services.

A deflator is a statistical tool that expresses how prices have evolved over a specific period. Its function is to “normalize” economic figures by eliminating the noise generated by price changes, leaving only significant variations visible. When a figure has been subjected to this adjustment, it is called “deflated.”

The process requires selecting a reference year or base year. For example, when analyzing the CPI (Consumer Price Index), each measurement is compared against this base year to determine the rate of price variation, which is commonly known as the inflation rate.

Practical example: Nominal GDP versus Real GDP

Imagine an economy produces goods and services worth 10 million euros in the initial year. The following year, the figure rises to 12 million. At first glance, it would seem there was a 20% growth. However, if during that same period prices increased by 10%, the reality is different.

When applying deflation considering that 10% price increase, we find that the real growth of the economy was only 10%. The GDP reflecting this correction is called real GDP (12 million deflated results in 11 million in constant values), while the original 12 million is known as nominal GDP. The CPI deflator is precisely what allows making this distinction and understanding the true dynamism of an economy.

CPI Deflation and Taxation: The Debate on Personal Income Tax (IRPF)

Why is deflating IRPF a current topic?

In high inflation contexts, such as those recorded in recent years in Europe and the United States, many governments face a dilemma. When a worker receives a salary increase to maintain their standard of living amid rising prices, they end up paying higher tax brackets if the tax system is not adjusted. This means that, although nominally earning more, their real purchasing power may decrease due to the higher tax burden.

The Personal Income Tax (IRPF) in Spain is progressive, meaning higher income levels are taxed at higher rates. Deflating IRPF involves adjusting the tax brackets according to the evolution of the CPI, ensuring that a taxpayer does not see their tax burden increase simply because of a salary increase that barely compensates for the loss of purchasing power.

International practice versus the Spanish situation

Countries like the United States, France, Germany, and Nordic nations implement this adjustment regularly. In the US and France, it is done annually; Germany does it every two years. In Spain, national-level deflation has not been carried out since 2008, although some autonomous communities have recently begun adopting similar measures in their regional tax brackets.

Since IRPF in Spain has both national and regional components, the effectiveness of this measure depends on its coordinated application at both levels. If only implemented regionally, its benefits will be limited.

Resilient Investments in the Face of Inflation and Credit Restrictions

Commodities: gold and raw materials as a refuge

Historically, gold has served as a store of value during periods of economic instability. Unlike fiat currencies, whose purchasing power erodes with inflation, gold maintains its intrinsic value and often appreciates when confidence in national currencies declines.

When interest rates reach high levels, government bonds become a more attractive alternative than historically, but gold remains interesting for investors seeking diversification without direct exposure to credit risk. Gold’s short-term volatility can be significant, but its long-term trend has been upward, reflecting its capacity to preserve wealth in contexts of monetary depreciation.

Equities: selectivity within volatility

The year 2022 clearly demonstrated that high inflation and rising interest rates exert negative pressure on stock markets. Companies face higher financing costs, compressing profit margins, and investors demand higher returns to justify the risk.

However, not all sectors behave identically. Companies providing essential products and services, or operating in sectors with resilient demand during economic crises, can maintain or even improve their performance. The energy sector experienced record gains in 2022, while technology suffered significant declines. For long-term investors with liquidity available, correction periods can present accumulation opportunities at depressed prices, knowing that historically markets recover after sharp declines.

Currency Market: volatility and opportunities

In inflationary contexts, interest rate differentials between economies play a crucial role in exchange rates. A currency from a country with high inflation tends to depreciate against currencies from economies with controlled inflation. This creates opportunities for investors anticipating currency movements, although the forex market is notoriously volatile and requires considerable experience.

Leverage available in currency markets amplifies both gains and losses, so it is not recommended for investors without experience in derivatives and risk management.

Benefits and Limitations of Deflating IRPF

Arguments in favor

Proponents argue that it preserves the fairness of the tax system. They contend that taxpayers should not be penalized fiscally for receiving salary adjustments that simply aim to maintain their standard of living amid the loss of purchasing power caused by inflation. From this perspective, deflating CPI in IRPF brackets is a matter of tax justice.

Additionally, if taxpayers retain more disposable income after deflation, they could potentially increase their capacity to invest, which might stimulate demand for financial and real estate assets.

Arguments against

Critics point out that this measure disproportionately benefits higher-income segments due to the progressive nature of the tax. A low-income taxpayer experiences smaller absolute tax reductions compared to someone with high income.

They also warn that regaining purchasing power could increase aggregate demand, pushing prices upward and frustrating central banks’ efforts to control inflation through demand restriction. Finally, any reduction in tax revenue limits governments’ ability to fund essential public services such as education and healthcare.

Limited real impact

It is important to note that the tax savings from deflating IRPF for most taxpayers amount to a few hundred euros annually. Therefore, although the measure has conceptual merit, its macroeconomic effects in terms of stimulating investment or consumption are likely modest.

Practical Recommendations for Investors

In an environment of persistent inflation and restrictive tax policies, considering several aspects is essential:

Comprehensive diversification: allocate investments among assets that historically perform well with inflation (defensive stocks, real estate, commodities) and those offering protection against credit risk (sovereign bonds from solid economies, gold).

Rigorous fundamental analysis: within the stock market, identify companies whose business models allow them to pass inflationary pressures to prices without losing demand.

Consideration of tax impacts: investment returns are taxed under IRPF, so a deflation that increases disposable income could effectively improve net profitability for investors. However, this should not be the primary factor in investment decisions.

Time horizon: short-term volatility is inevitable in inflationary contexts, but investors with medium- and long-term horizons tend to achieve positive historical results, taking advantage of dips to accumulate positions.

Conclusion

Deflating is an essential mechanism for comparing economic magnitudes over time, eliminating price distortions. Its application to tax systems, such as in the case of Spanish IRPF, aims to preserve equity and purchasing power during periods of high inflation. Although immediate benefits for individual taxpayers are modest, the underlying principle has economic relevance.

For investors, the challenge lies in building resilient portfolios that combine protection against inflation (real assets, real estate, commodities) with selective positions in equities and currencies. Tax deflation could free additional income to expand investment capacity, but it should not form the basis of an investment strategy. Financial education, deliberate diversification, and patience remain the fundamental pillars for thriving in inflationary economies.