Deflact the CPI: How to Protect Your Purchasing Power During Inflation

The year 2022 will go down in economic history as the turning point in global monetary policies. Europe and the United States experienced unprecedented interest rate hikes in decades, a direct response to the record inflation reaching levels not seen since the 1980s. In Spain, inflation stood at 6.8% as of November 2022, systematically eroding the purchasing power of millions of citizens. In response to this scenario, a fiscal measure has emerged that sparks intense debate: deflating the CPI through adjustment of tax brackets.

Why Is Deflating the CPI Fundamental in Economics?

Comparing economic performance over time seems straightforward: just look at whether incomes increase from one period to another. However, this direct comparison hides a crucial reality: price movements mask actual economic gains. An economic phenomenon can improve nominally but deteriorate in real terms.

To address this problem, economists use a deflator: an index that expresses the change in prices over a given period, allowing the isolation of volume variations from price fluctuations. When a value is adjusted using this deflator, the deflated figure is obtained, reflecting true productive or purchasing capacity.

A practical example: Imagine a country produced goods and services valued at 10 million euros in year 1. In year 2, nominal production grew to 12 million. At first glance, this suggests a 20% growth. But if prices increased by 10% in that same period, the real growth is just 10%. This deflated figure is called real GDP (11 million euros), different from nominal GDP (12 million). The CPI deflator works similarly: it adjusts comparisons of economic variables by removing inflation noise to reveal the genuine change.

Deflating the CPI: Practical Application in the IRPF

When Spanish politicians debate deflating the CPI, they generally refer to a specific fiscal measure: reducing the tax burden of the Personal Income Tax (IRPF) by adjusting the progressive tax brackets to the current inflation context.

What happens without this measure?

A taxpayer receives a 5% salary increase as compensation for inflation. However, this nominal increase places them in a higher tax bracket, resulting in a higher tax rate. Although they nominally earn more money, their real purchasing power decreases due to the double pressure of inflation and a higher tax burden.

Deflating the CPI means adjusting these tax brackets so that a taxpayer receiving a merely nominal increase is not penalized with higher taxation. In other words, the fiscal structure is adapted to the new price scenario, ensuring that the progressivity of the tax does not artificially penalize those who simply compensate for the loss of purchasing power.

International Situation

In the United States, France, and Nordic countries, this adjustment is made annually. Germany does it every two years. In Spain, at the national level, it has not been implemented since 2008, although various autonomous communities have announced their adoption for upcoming fiscal years. Since IRPF has both national and regional components, partial application has limited effects.

Advantages and Criticisms of Deflating the CPI

Arguments in favor:

• Preserves the purchasing power of families in inflationary contexts
• Prevents taxpayers from losing buying capacity due to automatic fiscal changes
• Distributes the tax burden more equitably

Arguments against:

• The biggest beneficiaries are high incomes, due to the progressivity of IRPF
• Reducing fiscal revenue during inflation can hinder funding public services (education, healthcare)
• Increasing available purchasing power can stimulate demand, potentially worsening inflation

Investment Strategies in an Inflationary Context

Inflation and high interest rates impact different assets differently. If the CPI is deflated and investors’ disposable income increases, better investment opportunities could arise.

Commodities: Gold as a Safe Haven

Gold has historically served as a hedge against inflation. When currency loses value, gold tends to maintain or increase its value, regardless of national economic conditions. During periods of high interest rates, investors often turn to gold as an alternative to government bonds, which generate taxable income. However, in the short and medium term, gold prices show significant volatility, although long-term appreciation remains consistent.

Stocks: Opportunities in Adversity

Inflation and high rates generally pressure the stock market: they reduce investors’ purchasing power and increase corporate financing costs. In 2022, we saw this effect, with energy sectors recording record profits while technology stocks plummeted.

However, disparities exist within the market: companies producing essential goods or serving inelastic demands tend to resist better. For investors with liquidity and a long-term horizon, recessions create opportunities as asset prices of quality stocks decline, allowing for recovery-driven gains.

Currencies: Forex in Inflationary Contexts

The currency market is directly affected by changes in inflation and interest rates. Elevated inflation typically depreciates the national currency, potentially appreciating foreign currencies. However, forex is highly volatile and leveraged, presenting significant risk, especially for inexperienced investors. Exchange rate volatility responds to multiple factors: economic conditions, political events, and market sentiment.

Diversification: The Fundamental Strategy

Given the dispersion of inflation impacts, diversification remains crucial: combining stocks, real estate, commodities, and inflation-adjusted treasury securities reduces systemic risk and enhances portfolio resilience.

Real Impact of Deflating the CPI on Investments

Deflating the CPI to expand available purchasing power could generate:

• Increased demand for investments, especially income-generating assets (stocks, real estate)
• Reallocation of capital toward sectors benefited by fiscal incentives (renewable energy, technology)
• Marginal increase in aggregate investment

However, it is important to note that the individual economic benefits of this measure are modest: typical savings amount to hundreds of euros annually. Expecting that deflating the CPI in isolation will revolutionize national investment levels would be overly optimistic.

Final Reflection

In environments of persistent inflation and restrictive fiscal policies, deflating the CPI is a tool to protect taxpayers’ real purchasing power. Its effectiveness depends on consistent and coordinated implementation across government levels. For investors, the real focus should be on smart diversification, selecting assets resilient to inflation, and understanding the actual tax impact (post-deflation) on returns.

Investing in inflationary times does not require complex instruments but strategic discipline: knowing which assets generate real, not nominal, value, and positioning portfolios accordingly.