in Panama over the 1997-2003 period. Although international migration is likely to be an important element in the dynamics of the Panamanian labor market, it is not considered in this analysis due to the difficulties of modeling this flow in a single-country setting. Labor mobility across formal and informal activities is not limited, but informal workers earn significantly lower salaries (on average, 20 percent of formal sector wages), giving rise to potentially large productivity effects when demand for one of the activity types rises. Finally, the model assumes no change in the degree of resource utilization, or fixed employment. This assumption is consistent with the available econometric evidence for Panama (see Galliani, 2006), which shows that the unemployment rate has been fairly steady at around 6 percent and has not changed much during economic upswings or downturns.

The volumes of government current and investment spending (including investments in the canal) are fixed as shares of real GDP, while the deficit (in real terms) is also fixed. Public revenues adjust to clear the government balance by means of a flexible household direct tax rate.<sup>7</sup> The investment-to-GDP ratio is fixed at the base year value and a flexible marginal propensity to save out of household disposable income ensures that total saving equals total investment. The current account balance is fixed by the available quantity of foreign saving and the exchange rate is the numeraire, which means that domestic prices are determined relative to a fixed-cost basket of foreign goods.<sup>8</sup> The model is solved in a recursive dynamic mode, in which subsequent end-of-period equilibria are linked with a set of equations that update the main macro variables. There are three determinants of real GDP growth in the model: labor supply growth, capital accumulation, and increases in productivity. The volumes of both types of labor grow exogenously at the rate of growth of the working age population (ages 15-64), obtained from World Bank population forecasts. The capital stock in each period is the sum of depreciated capital from the period before and new investment. For all sectors, capital productivity remains fixed throughout the model horizon, while growth in labor productivity in the business-as-usual (BaU) scenario is calibrated to real GDP growth in the World Bank‘s medium- and long-term forecast for Panama.<sup>9</sup> In all other scenarios, labor productivity is fixed in each period at the BaU level, and GDP growth becomes endogenous.<sup>10</sup> Thus, real GDP growth may differ from BaU due to faster/slower accumulation of capital or shocks to the productivity shift parameters, allowing the variations in GDP growth across scenarios to be directly attributed to the simulated policy reforms.

> 7 Although other assumptions about closing the government balance, such as adjustments in indirect taxes, increased borrowing, or reduced spending, are also plausible, choosing the direct tax rate as an instrument is a fairly neutral way (in an allocative sense) of restoring  fiscal balance in case of a shock. It also simplifies welfare measurements since the incidence of making up the budgetary shortfall falls squarely on consumers (in contrast to indirect taxes, which, for example, may motivate producers to allocate a larger share of production toward exports which may be taxed at a lower rate).

> 8 We use the deflator of GDP at factor cost as a measure of movements in the real exchange rate.

> 9 Labor productivity growth in the canal sector is always exogenous.

> 10 Thus, in the absence of any shocks, the BaU GDP growth rate is reproduced exactly.

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