Country Focus: Panama: Reforms and Growth Hold Key to Reducing Inequality

International Monetary Fund. External Relations Dept.
Published Date:
June 2006
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Over the past 15 years, a sophisticated financial system, relatively sound fiscal policies, and a number of structural reforms have helped spur economic growth in Panama. But not all Panamanians have benefited equally. Advanced, export-oriented sectors coexist with less prosperous domestically oriented ones, including an informal economy characterized by significant poverty and inequality. How can Panama ensure that the fruits of economic success are more widely shared? Sustained economic growth is a necessary underlying condition for poverty reduction, but expanded educational opportunities, increased labor market flexibility, and improved governance will also be crucial.

Panama has a dual economy. Its sophisticated regional financial center, newly modernized Panama Canal, booming construction industry fueled partly by foreign demand, and rapidly growing tourism and other industries oriented toward the export of services coexist with a 37 percent poverty rate and persistent unemployment, notably in rural areas. Indeed, a large share of the labor force, lacking the skills needed to take up jobs in Panama’s fast-developing industries, is still concentrated in the informal sector.

Strong growth, persistent inequality

Between 1990 and 2004, Panama was the second-fastest-growing economy in Latin America (see chart below left). Its GDP per capita, $4,400 in 2004, is high by regional standards (adjusted for purchasing power parity, it is estimated at about $7,000).

But strong economic growth, with a 14 percent increase in GDP per capita between 1997 and 2003, has not yet translated into significant poverty reduction. Over the same period, the poverty rate declined by only ½ of 1 percentage point to 37 percent. In 2003, an estimated 63 percent of the rural population continued to live in poverty, and one in six Panamanians lived in extreme poverty—that is, on less than $1.50 a day. Only 2.2 percent of the population has been lifted out of extreme poverty (see chart below right). Why have high rates of poverty persisted? High unemployment has been one factor. Although the unemployment rate has declined steadily since 2001, it remained in double digits until 2005, when it dropped to 9.6 percent. Average real wages have also been in decline since the start of the 1990s.

Vibrant growth

Panama’s average growth rate for 1990-2004 was among the strongest in Latin America. Only Chile outperformed Panama.

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Data: IMF, International Financial Statistics.

One intuitively expects economic growth to result in better overall standards of living, but empirical evidence on the relationship between inequality and growth is mixed. In the short run, increased growth tends to be associated with increased inequality. Measures to boost growth—such as tax cuts and incentives for particular industries or investors—can boost private sector activity, but they may make the tax system more regressive and deprive the country of revenues needed to finance poverty-reducing social programs.

However, over time, increased growth does tend to be associated with declines in inequality, though this relationship need not be causal. It can be driven by structural changes that both reduce inequality and poverty and enhance economic performance. Such changes include reforms designed to upgrade human capital (through expanded education and training), improve the efficiency of labor markets, strengthen the quality of governance, and facilitate the development of financial markets.

But little progress on poverty

Despite strong growth, Panama has seen only minor gains and has lost some ground on the poverty front.

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Data: Panamanian Ministry of Economy and Finance.

Roots of the dual economy

Consistent with this general theoretical argument, Panama’s dual economy can be explained by the success of tax incentives and mixed results with long-run structural reforms. The recent economic recovery has been driven by exports of services and construction. Both sectors benefited from generous tax incentives, including a 20-year property tax exemption for newly built properties. These incentives have intensified the dual-economy phenomenon by targeting particular industries and by allowing those who purchase expensive property to substantially reduce their tax obligations. The low level of overall tax collections (8.5 percent of GDP in 2004), which clearly reflects a low tax burden on the private sector, also constrains the government’s ability to finance social programs—especially since debt-interest payments absorb almost half of all tax revenues.

In its pursuit of long-run structural reforms, Panama has had more success on the financial side. Major strides have been made in developing credit markets, and these, in turn, have helped combat poverty by broadening access to credit and mitigating business start-up costs. More generally, the Panamanian financial system—aided by full dollarization, strong creditor rights, and prudent banking supervision and regulation—has developed rapidly, with credit broadly avail-able to businesses and individuals. Growth has also been facilitated by privatization, transfer of the administration of the Panama Canal from the United States, establishment of special economic zones, and the use of concessions to encourage investment in infrastructure.

If it is to sustain high growth and make substantial progress in reducing poverty, however, Panama will need to take additional steps in a number of areas, notably human capital development, labor market rigidities, and the quality of governance.

High cost of rigidity

Panama’s rigid labor market rules appear to have led to higher informal employment.

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Note: Higher values correspond to more rigid regulations. The index is based on hiring, firing, and overtime work regulations.

Data: World Bank Doing Business survey.

Further reforms needed

Benefiting from its competitive advantages over other countries in the region, Panama’s transport, tourism, and telecommunications industries have significantly expanded exports of services. Rapid expansion in these areas, however, has quickly exhausted the supply of suitably qualified labor. A recent survey of labor demand and supply pointed to a shortage of experts in maritime disciplines, tourism, and certain technical subjects and a surplus of students of law and management. While the government’s efforts to promote English-language education programs are welcome, further measures (such as targeted government-supported training programs) are needed to ensure that the qualifications of the labor force match the demands of Panama’s rapidly developing industries.

The country’s growth rate and poverty reduction efforts could also benefit from measures to ease the comparatively rigid rules (see chart below) on hiring and firing staff and the use of overtime work. The rules are intended to protect workers but appear to achieve the opposite effect by encouraging businesses to use informal contractual arrangements. Indeed, workers in the informal sector (estimated to account for 42 percent of employment) often have lower wages, higher chances of being underemployed, and lower, if any, social security protection.

Panama can improve governance and streamline the heavy regulation of businesses—both steps that would be particularly helpful for small and mediumsized businesses. Streamlining the procedures for starting up and running small and mediumsized businesses and further increasing the transparency of public resources management need to be made priorities. Finally, Panama’s high debt-to-GDP ratio calls for strong fiscal discipline, which would substantially reduce the burden of servicing public debt and free up resources for much-needed social programs.

Alexander Plekhanov

IMF Western Hemisphere Department

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