Compacts of Free Association: Development Prospects Remain Limited for Micronesia and Marshall Islands
Published: 2006-06-27T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: In 1987, the United States began providing economic aid to the Federated States of Micronesia (FSM) and the Republic of the Marshall Islands (RMI) through a Compact of Free Association. In 2004, through amended compacts with the FSM and the RMI, the United States committed to provide more than $3.5 billion until 2023. Joint U.S-FSM and U.S.-RMI compact management committees are required, among other things, to monitor progress toward specified development goals and address implementation of policy reforms to stimulate investment. The legislation implementing the amended compacts (P.L. 108-188) requires that GAO periodically report on political, social, and economic conditions in the FSM and the RMI. In compliance with this requirement, GAO examined each country's (1) political and social environment, (2) economic environment, and (3) status of economic policy reforms.
section_title: What GAO Found
paragraphs: FSM and RMI political and social conditions challenge, respectively, effective compact grant implementation and health and education progress. Regarding political conditions, for example, the FSM states and national government have been unable to agree on implementation of the compact infrastructure grant, while the RMI government has had difficulty securing agreement from land owners regarding its use of leased land for compact-related projects. Social challenges in both countries include persistent health and education problems despite substantial expenditures. For instance, the FSM and the RMI have low immunization rates relative to other countries with similar income levels. The FSM and the RMI economies show limited potential for achieving longterm development objectives. Both economies depend on public sector expenditures--funded largely by external assistance--and government budgets have growing wage expenditures, heightening the negative fiscal impacts they will face as compact grants decline. As a result, long-term economic growth must come from the private sector and increased income sent home from FSM and RMI emigrants ("remittances"). However, poor business environments hamper private industry in both countries, and FSM and RMI emigrants' lack of marketable skills hinders increasing revenue from remittances. Compact management committees have not discussed the countries' progress toward budgetary self-reliance and long-term economic advancement at their annual meetings. FSM and RMI progress in key policy reforms has been slow. Country officials reported passing some new mortgage and bankruptcy laws, but other needed reforms have not been implemented. For example, according to economic experts, tax systems remain inequitable and inefficient and foreign investment regulations remain confusing and relatively burdensome. FSM and RMI development plans include reform objectives in each of these areas; however, compact management committees have not addressed the nations' slow progress in implementing reforms.

section_title: Letter
paragraphs: From 1987 to 2003, the United States provided about $2.1 billion in  economic assistance to the Federated States of Micronesia (FSM) and the  Republic of the Marshall Islands (RMI) through a Compact of Free  Association. In 2003, the U.S. government negotiated new compact  provisions with the FSM and the RMI that established an estimated $3.6  billion in continued U.S. assistance from fiscal year 2004 through fiscal  year 2023. These “amended” compacts provide for decreasing annual  grant assistance over the 20-year period, paired with increasing  contributions to trust funds that are to provide income for each country  after compact grants cease. The amended compacts identify the twenty  years of grant assistance as intended to assist the FSM and the RMI  governments in their efforts to promote the economic advancement and  budgetary self-reliance of their people. To this end, the amended compacts  provide for continued economic assistance in the form of grants to sector- specific areas, such as education, health, public infrastructure, and private  sector development, prioritizing education and health.
The amended compacts and their subsidiary agreements include  requirements that the FSM and the RMI submit development plans and  provide regular financial and performance reports. The amended  compacts also require that the U.S. and the FSM Joint Economic  Management Committee (JEMCO) and the U.S. and the RMI Joint  Economic Management and Financial Accountability Committee  (JEMFAC) meet at least once annually to evaluate FSM and RMI progress  in achieving the objectives specified within their development plans, to  identify problems encountered, and to recommend ways to increase the  effectiveness of compact grant assistance.
Regarding specific objectives within the development plans, the legislation  implementing the amended compacts directs JEMCO and JEMFAC to  address objectives related to the implementation of policy reforms to  encourage investment and to improve tax income. The fiscal procedures  agreements direct JEMCO and JEMFAC to monitor FSM and RMI progress  toward budgetary self-reliance and long-term economic advancement. The  legislation implementing the amended compacts also requires that the  United States and GAO periodically report on political, social, and  economic conditions in the FSM and the RMI as well as on the use and  oversight of U.S. assistance to those nations. In compliance with the  legislation’s requirement, this report examines each country’s (1) political  and social environment regarding, respectively, compact grant  implementation and health and education conditions; (2) economic  environment, particularly respecting potential for achieving budgetary  self-reliance and long-term economic advancement; and (3) status of  economic policy reforms.
To address our reporting objectives, we reviewed U.S., FSM, and RMI  annual compact reports for 2004; FSM and RMI development plans; FSM  and RMI economic reports and statistics; political assessments by the U.S.  Department of State (State) and Transparency International; and Asian  Development Bank (ADB), World Bank, and International Monetary Fund  (IMF) reports on both economies. We interviewed officials from State and  the U.S. Department of the Interior (Interior) as well as country experts at  the ADB, the IMF, the World Bank, and the Pacific Islands Development  Program at the East-West Center. We also interviewed relevant officials,  banks, and numerous representatives from private industry (including  local chambers of commerce) in the four FSM states and in the RMI. We  determined that the social and economic data presented in this report are  sufficiently reliable for our purposes. We conducted our review from  August 2005 through March 2006 in accordance with generally accepted  government auditing standards. A detailed description of our scope and  methodology is included in appendix I of this report.
subsections: section_title: Background
paragraphs: After more than 40 years under U.S. administration as part of the United  Nations Trust Territory of the Pacific Islands, the FSM and the RMI  became sovereign nations in 1978 and 1979, respectively. For the last 20  years, the United States’ relationship with the two countries has been  defined by the original Compact of Free Association and the subsequent  amended Compacts of Free Association.
subsections: section_title: Compact of Free Association, 1986 to 2003
paragraphs: In 1986, the United States, the FSM, and the RMI entered into the original  Compact of Free Association. Representing a new phase of the unique  relationship between the United States and these island areas, the  compact provided a framework for the United States to work toward  achieving its three main goals: (1) to secure self-government for the FSM  and the RMI, (2) to ensure certain national security rights for all of the  parties, and (3) to assist the FSM and the RMI in their efforts to advance  economic development and self-sufficiency. The first goal was met; the  FSM and the RMI are independent nations. The second goal has also been  achieved with the compact’s establishment of several key defense rights  for all three countries. The defense relationship continues with, among  other things, U.S. access to military facilities on Kwajalein Atoll in the RMI  through 2016. The compact’s third goal was to be accomplished primarily  through U.S. direct financial assistance to the FSM and the RMI. For the  15-year period covering 1987 to 2001, funding was provided at levels that  decreased every 5 years. For 2002 and 2003, during negotiations to renew  expiring compact provisions, funding levels increased (see fig. 1) to equal  an average of the funding provided during the previous 15 years plus  inflation. For 1987 through 2003, compact financial assistance to the FSM  and the RMI was estimated, on the basis of Interior data, to be about $2.1  billion.
Economic development and self-sufficiency were not achieved under the  original compact. Both nations remained dependent on U.S. funds; total  U.S. assistance accounted for more than 50 percent of government  revenues throughout the compact period. In addition, FSM and RMI GDP  estimates reveal that per capita GDP at the close of the compact had not  exceeded, in real terms, early 1990s levels in either country (see fig. 2).  Although U.S. direct assistance maintained standards of living that were  higher than could be achieved without support, we found previously that  compact funds spent on economic development were largely ineffective in  promoting economic growth. For example, compact funds were used to  support general government operations that, among other things,  maintained high levels of public sector employment and wages, creating  disincentives to private sector growth. Compact funds were also used to  support business ventures, most of which have failed. In our examination  of a wide range of projects funded under the compact, we found that many  projects experienced problems due to poor planning and management,  inadequate construction and maintenance, or misuse of funds. In 2000, we  recommended, among other things, that the Secretary of State direct the  Special Negotiator for the Compact of Free Association to negotiate  amended compact provisions that include assistance provided through  grants targeted to priority areas, expanded reporting and consultation  requirements, and the ability to withhold funds for noncompliance with  compact terms and conditions.
The compact also gave citizens of both nations the rights to live and work  in the United States as “nonimmigrants” and to stay for long periods of  time. Further, the compact exempted FSM and RMI citizens from meeting  U.S. passport, visa, and labor certification requirements when entering the  United States. In 2001, we reported that during the compact, a significant  number of FSM and RMI citizens had migrated to the United States and  U.S. island areas.
section_title: Amended Compacts of Free Association
paragraphs: The United States negotiated separate amended compacts with the RMI  and the FSM that went into effect on May 1, 2004, and June 25, 2004,  respectively. The amended compacts continue the defense relationship,  including a new agreement providing U.S. military access to Kwajalein  Atoll in the RMI through 2086; strengthen immigration provisions; and  provide direct financial assistance, in the form of grants, to the FSM and  the RMI for fiscal years 2004 to 2023 (see table 1). To promote FSM and  RMI budgetary self-reliance and economic advancement, the amended  compacts and their subsidiary agreements, along with the countries’  development plans, target grant assistance to six sectors—education,  health, public infrastructure, the environment, public sector capacity  building, and private sector development—prioritizing two sectors,  education and health. In addition to providing grant assistance, the  amended compacts provide for the establishment of trust funds for both  countries that can provide income after annual compact grants cease. The  amended compacts, their subsidiary agreements, and the U.S.  implementing legislation also establish numerous reporting and  accountability requirements—including the legislation’s direction to the  JEMCO and JEMFAC to specifically address economic policy reforms to  encourage investment and improve tax income.
Including estimated inflation adjustments, total combined compact grant  assistance to the two countries is projected at an estimated $3.6 billion  over the 20-year assistance period. However, to provide increasing U.S.  contributions to the FSM’s and the RMI’s trust funds, grant funding will  decrease annually. Assuming current population growth estimates from  the U.S. Census Bureau, this decrease in grant funding will result in falling  per capita grant assistance over the funding period and relative to the  original compact (see fig. 3).
While the level of annual grant assistance to both countries decreases each  year, contributions to trust funds—meant to provide an ongoing source of  revenue after fiscal year 2023—increase annually by a comparable amount.  In comparing projected trust fund revenue with the fiscal year 2023 grant  level, we reported earlier that, under certain conditions, the trust fund  revenue available in 2024 may be less than even the lower level of grant  funding in 2024. For example, at an assumed annual 6 percent rate of  return, earnings from the FSM’s trust fund would be lower than expiring  grant assistance in 2024, while earnings from the RMI’s trust fund would  encounter the same problem by 2040. If the trust funds consistently earn  a higher rate of return, or if additional contributions to the funds are  provided, the probability rises that the trust funds could provide a  sustainable income source at the level of fiscal year 2024 grants. However,  if the trust funds experience market volatility with years that have  negative returns, the probability that these funds would yield income  sufficient to replace expiring grant assistance declines.
section_title: FSM and RMI Face Key Political and Social Challenges
paragraphs: Although the FSM and the RMI are stable democracies, both countries face  political and social challenges with regard to improving grant  implementation and health and education conditions. U.S. and country  officials told us that political conditions, including a weak federation in  the FSM; disputes over public institutions’ and government use of land on  Kwajalein Atoll in the RMI; and both governments’ lack of communication  with their constituencies have hindered compact implementation and  service delivery. At the same time, despite relatively high health and  education expenditures, both countries face development challenges in  these sectors. For example, although the Millennium Challenge  Corporation (MCC)—which evaluates indicators with a relationship to  growth and poverty reduction—ranks the FSM and the RMI in the top 20  percent for health expenditures relative to other lower-middle-income  countries, it ranks both countries in the bottom third for a key health  indicator, immunizations.
subsections: section_title: Despite Stable Democratic Systems, Political Factors in the FSM and the RMI Challenge Compact Implementation
paragraphs: The FSM and the RMI are established democracies with free and peaceful  elections. According to State and Interior, each democracy is stable  despite the challenges of having hierarchical traditional structures; islands  with scattered populations; and a citizenry of distinct cultures, languages,  and histories. Each country also has a vocal civil society evidenced by  religious organizations and nongovernmental organizations (NGO) that  have been active on some political issues. Internationally, both countries  also participate in various regional organizations, many of which address  trade, energy, and environmental challenges faced by island nations. For  example, the FSM and the RMI are members of the Forum Fisheries  Agency—which promotes sustainable management of fisheries in the  Pacific—and the South Pacific Applied Geoscience Commission, which  promotes sustainable development of offshore resources for member  countries.
Despite the two countries’ stable democratic systems, interviews with  U.S., FSM, and RMI officials and civil society representatives indicated  that key aspects of the FSM’s and the RMI’s political environments hinder  effective compact grant implementation.
Lack of government consensus. State and Interior officials reported  that the FSM’s weak federal structure inhibits compact grant  implementation. Because each state has its own constitution and authority  over budgetary policies, the central government that is represented on  JEMCO does not control the majority of compact funds and have been  unable to secure agreement from the state governments regarding  compact needs. As a result, FSM access to the compact infrastructure  grant, for example, has been delayed for more than 2 years owing to  national and state disagreements over infrastructure priorities. Similarly,  the RMI government and landowners on Kwajalein Atoll have been  disputing government use of leased land and management of public  entities on the atoll. Such tensions have negatively affected the  construction of schools funded by compact grants and the management of  the Kwajalein utility company and the Kwajalein development authority,  two entities that also receive compact funds.
Lack of government communication. Interviews with U.S., FSM and  RMI departmental officials, private sector representatives, NGOs, and  external economic experts revealed a lack of communication and  dissemination of information by each government on wide-ranging issues,  including JEMCO and JEMFAC decisions, departmental budgets,  economic reforms, legislative decisions, fiscal positions of public  enterprises, and economic statistics. Additionally, private sector  representatives in several FSM states reported that the public radio station  serves as the government’s primary means of disseminating information  but is often nonoperational or censored—a complaint confirmed by the  U.S. State Department’s 2004 Report on Human Rights Practices in the  FSM. In the RMI, a State official and an official from the RMI Council of  NGO’s reported that the government had been criticized—most strongly  by environmental NGO’s and a leading women’s NGO (Women United  Together Marshall Islands)—for not holding public hearings or  disseminating sufficient information regarding a proposed dry dock.  According to the World Bank, Transparency International, and other  development experts, lack of information about government activities  creates uncertainty for public, private, and community leaders, which can  inhibit grant performance and improvement of social and economic  conditions.
section_title: Despite High Expenditures, Both Countries Remain Challenged in Improving Health and Education Conditions
paragraphs: Although FSM and RMI health and education expenditures are relatively  high, certain conditions in both countries’ health and education sectors are  poor. According to the World Bank, among 171 countries for which it  reports aid per capita, the RMI and the FSM ranked 5th and 6th highest,  respectively, with per capita aid greater than $900 in 2003. Much of this  aid is directed toward health and education. MCC provides economic  assistance to developing countries, with eligibility determined partially by  evaluating a country’s performance—relative to other countries within its  income group—on select indicators associated with economic growth and  poverty reduction. MCC ranks the FSM in the top 35 percent (in the 81st  and 67th percentile, respectively) for expenditures on health and primary  education, and it ranks the RMI in the top 1 percent for both indicators,  relative to other lower-middle income countries that qualify for MCC  assistance. However, for another health-related indicator— immunizations—MCC ranks both countries in the bottom third: the FSM in  the 33rd percentile and the RMI in the 13th percentile. According to the  World Bank’s World Development Indicators (WDI), the FSM also  performs relatively poorly in provision of safe water or sanitation—a  service necessary for improved health outcomes. According to WDI, only  28 percent of FSM citizens have access to improved sanitation, compared  with an average of 57 percent in all lower-middle income countries. In the  RMI, the 1999 census suggests that 85 percent of the population has access  to safe water, although the RMI 2003 statistical yearbook reports that  recent tests in urban and rural areas indicate that a significant number of  potable water sources, such as groundwater wells and water catchments— 30 percent or more in some cases—are contaminated and deemed unsafe  for human consumption. (For further information on socioeconomic  conditions in the FSM and the RMI, particularly in relation to regional  averages, refer to app. II.)
Country studies and health and education officials in the FSM and the RMI  also highlight other challenges—for example, the increasing prevalence of  lifestyle diseases such as diabetes or hypertension; youth health issues;  and poor teaching skills. According to the FSM Department of Health, 80  percent of 35 to 64 year-olds are overweight, and the number of cases  involving diabetes, hypertension, heart disease, and cancer increased in  the late nineties. Likewise, the RMI Ministry of Health reports that  diabetes figured as the leading cause of adult morbidity in 2000 and 2001.  Although the RMI has made progress in reducing overseas referrals since  2001, the rising prevalence of lifestyle diseases poses challenges for  delivery of health services in both nations. The care and treatment of such  diseases often involves expensive referrals abroad, lowered funding for  public health programs that serve impoverished populations, and burdens  on household and national budgets. Future health outlays will also be  affected by health challenges facing FSM and RMI youths. FSM and RMI  health officials indicated concern about growing youth problems such as  suicides, sexually transmitted diseases, and teen pregnancy. With regard to  teacher qualifications, the FSM Department of Education reports that 90  percent of teachers need to upgrade skills to meet new certification  standards (a bachelor’s degree with courses in child development). In the  RMI, a 2004 Ministry of Education assessment reported that more than 50  percent of teachers had failed basic English literacy tests.
section_title: FSM and RMI Economies Show Limited Potential for Self-reliance and Long-term Advancement
paragraphs: In the past 2 years, the FSM and the RMI economies have performed  modestly and have been characterized by continued dependence on  external assistance, suggesting limited prospects for achieving  development goals of budgetary self-reliance and long-term economic  advancement. Private sector employment has largely stagnated in both  countries, whereas public sector expenditures continue to account for  almost two-thirds of GDP. Despite the amended compacts’ structure of  declining grant assistance, the FSM and the RMI public sectors have grown  while tax revenues remain relatively small. Unless each nation can secure  other donor assistance, maintenance of living standards over the long term  will likely require private sector expansion or increased remittances. The  FSM and the RMI private sectors face significant constraints to growth,  however, and FSM and RMI emigrants’ current lack of marketable skills is  a hurdle to increased remittance revenue. Although the amended  compacts’ fiscal procedures agreements require JEMCO and JEMFAC to  monitor FSM and RMI progress toward budgetary self-reliance and long- term economic advancement, neither organization has discussed these  issues at its annual meeting or defined what actions they will undertake to  meet this requirement.
subsections: section_title: FSM and RMI Economies Depend on Government Spending of Foreign Assistance Instead of Private Sector Production
paragraphs: As in the original compact period, FSM and RMI economic conditions in  2004 and 2005 were characterized by dependence on foreign assistance. In  the FSM, 2004 and 2005 GDP fell owing to compact delays and a lower  level of assistance relative to 2003. For the RMI, the IMF estimates that  GDP expanded moderately owing to increased public sector expenditure  (see fig. 4). While the RMI also experienced compact delays in 2004, RMI  public expenditure increased in both 2004 and 2005, reflecting expected  compact funding at levels roughly equivalent to fiscal years 2002 and 2003,  when compact funds were temporarily increased. Both countries’ 2005  public sector expenditure—about two-thirds of which is funded by  external grants—remained at about 60 percent of GDP.
In both the FSM and the RMI, however, private sector activity has  remained relatively stagnant and exists largely to provide services to the  public sector. Since 2000, the estimated private sector share of GDP has  fallen in both countries and only Pohnpei state in the FSM has had modest  growth in private sector employment, principally in wholesale and retail  operations. Institutions such as the IMF and the ADB characterize the  private sector in both the FSM and the RMI as isolated from international  opportunities, given each economy’s high dependence on imports and  negligible foreign investment.
section_title: FSM and RMI Will Likely Face Significant Budgetary Pressure with Declining Compact Assistance.
paragraphs: Given the recent performance and structure of FSM and RMI government  budgets, both nations are likely to face significant budgetary pressure as  compact grants decline through 2023. Apart from 2002 and 2003, when  compact assistance was temporarily increased, FSM national and state  budgets have varied widely from year to year; however, each has had  recent budget deficits. RMI government finance statistics reported by the  IMF suggest that the RMI fiscal balance deteriorated after 2003 as well,  with an estimated deficit equivalent to 2 percent of GDP in 2005.  Economic experts emphasize that, structurally, both country’s budgets are  characterized by a small local revenue base and recent increases in  government payroll. As a result, unless other donors provide additional  assistance, expenditure reductions will be required as compact grants  decline.
FSM budget structure. Although tax revenue in the FSM increased  slightly in 2005, the FSM tax base is small and the growing wage bill is high  relative to regional standards. In 2005, FSM taxes provided an estimated  $29 million in revenue, or 23 percent of total revenue (compared with an  average of 17 percent from 2000 to 2004). In addition, the FSM  government receives fishing access fees from foreign vessels that fish in  its exclusive economic zone. However, the largest income source is  external grants, which, at $76 million, accounted for 60 percent of  revenues in 2005 (see fig. 5). In terms of expenditure, the largest FSM  expenditure component is public sector wages and salaries at an estimated  $60 million. This component grew from 36 percent of total expenditures  in 2000 to 2004 to 42 percent of total expenditures in 2005.
RMI budget structure. As a percentage of total revenue, the RMI’s tax  base is slightly larger than the FSM’s. As a percentage of total expenditure,  the RMI’s public sector wage bill is also relatively smaller, although its  wage bill increases have exceeded the FSM’s. Taxes in the RMI provide  about $22 million in revenue to the government, or roughly 26 percent of  total revenues (see fig. 6). The RMI also receives fishing access fees. At 64  percent of total revenues, external grants are the largest income  component, providing $54 million in 2005. The structure of RMI revenues  remained roughly the same over the past 5 years. However, RMI payroll  expenditures increased. In 2005, the RMI’s wage bill comprised 34 percent  of total expenditures, compared with the 2000 to 2004 wage bill of 31  percent. In actual value, the RMI’s wage bill increased from around $17  million in 2000 to around $30 million in 2005.
In addition to receiving compact grant assistance, the FSM and the RMI  receive substantial U.S. program assistance from agencies such as the U.S.  Departments of Agriculture, Education, and Health and Human Services.  The RMI also receives large grants from Japan and Taiwan and the FSM  receives large grants from Japan (see table 2) and reports having received  grants from China. As compact grants decline through 2023, government  fiscal balances and GDP could be supported, at least partially, by  increased noncompact assistance. However, such increases in assistance  are not guaranteed, may vary from year to year, and may not be flexible  enough to meet FSM and RMI budget needs.
Tax reform may provide opportunities for increasing annual government  revenue in the FSM and the RMI. For example, business tax schemes in  both nations are considered to be inefficient by the IMF, the ADB, and  other economic experts owing to a poor incentive structure and weak tax  collection. Various expert and country studies have concluded that  substantial tax reform could bring revenue growth by broadening the tax  base, altering the structure to be more equitable and business friendly, and  improving administration. However, although the FSM and the RMI  governments have made some improvement in tax administration, tax  revenues have largely stagnated. Revenue potential from further tax  reform will also vary by government (national and state) and will require  factors such as a sound design; adequate resources and capacity for tax  enforcement; government commitment for reform; and, ultimately, private  sector growth.
section_title: Key FSM and RMI Industries Face Multiple Constraints to Growth
paragraphs: FSM and RMI development plans identify fishing and tourism as key  potential growth industries. However, in both nations, fishing enterprises  have shown poor performance, and the number of tourists has been small  relative to other Pacific islands. In the FSM, the fisheries and tourism  sectors together provide about 6 percent of employment; commercial  fishing has been plagued by poor government investments in vessels and  infrastructure that have resulted in high debt levels, according to ADB  experts; and visitor arrivals have remained flat over the past 10 years  despite growth in Pacific island tourism. In the RMI, the fisheries and  tourism sectors together provide less than 5 percent of employment;  commercial fishing within the RMI’s exclusive economic zone has been  declining, and although visitor arrivals have increased modestly, they  remain small in number relative to other Pacific island nations. Economic  experts suggest that the FSM and the RMI fishing and tourism industries  could grow within specialized niche markets such as high-end tourism or  dock services. Such opportunities remain limited in scale, however, and  the IMF, the ADB and other economic experts suggest that growth in these  industries in both countries may be limited by current structural barriers  such as the following:    geographic isolation and small fragmented markets;    high airfares and poor flight connections;  lack of adequate hotel and airport infrastructure; low freight capacities and poor interisland shipping; inadequate transshipment facilities in some areas;   a growing threat of overfishing;  limited pool of skilled labor; and   high production costs in terms of labor, fuel, and other supplies.
In addition to facing structural barriers to growth, private industry in  general faces a costly business environment in both the FSM and the RMI  according to economic experts and U.S. and country officials. In  interviews, private sector representatives also expressed concern with  poor government provision of power, water, and infrastructure services  and government failures to pay bills owed to the private sector for services  rendered—a complaint confirmed by several government officials  including those from the Chuuk State legislature, the RMI Ministry of  Resources and Development, and the FSM Department of Economic  Affairs (see app. III for further information).
section_title: Prospects for Increased Remittance Income to the FSM and RMI Require More Skilled Migrants
paragraphs: FSM and RMI emigrants could provide increasing monetary support to  their home nations in the future, although evidence suggests that they are  currently limited in their income-earning opportunities abroad. World  Bank data show that remittances, or the personal funds that the foreign  born voluntarily send to their home countries, have become an important  source of financial flows to developing countries—in some cases  exceeding official development assistance and foreign direct investment.  For the FSM and the RMI, many citizens have taken advantage of U.S.  migration rights established by the original compact and extended by the  amended compacts. As of 2005, RMI data suggest that about 15,000  Marshallese have immigrated to the United States. FSM data suggests that  almost twice as many Micronesians live overseas. However, the current  level of remittance income provided by these emigrants is unknown. In the  RMI, the 2002 household survey suggests that RMI citizens send more  money out to RMI emigrants than they receive in remittances, owing to the  emigrants’ lack of high-paying jobs and inability to afford repatriation of  funds. Our previous work has shown that RMI and FSM emigrant  populations have limited income-earning opportunities abroad, largely  because of inadequate education and vocational skills. The 2003 U.S.  census of FSM and RMI migrants in Hawaii, Guam, and the  Commonwealth of the Northern Marianas Islands (CNMI) confirms this  characterization, showing that almost half of the emigrants live below the  poverty line (see table 3). Nonetheless, economic experts emphasize that  with an upgrading of skills, the FSM’s and the RMI’s free access and strong  historical links to the U.S. market create potential for the two nations to  achieve an expansion in remittance income that could contribute to long- term economic advancement.
section_title: Compact Management Committees Have Not Discussed Progress toward Self-reliance and Long- term Advancement
paragraphs: To date, JEMCO and JEMFAC have not discussed FSM and RMI progress  toward budgetary self-reliance and long-term economic advancement or  the role for compact grants in attaining these development goals. FSM and  the RMI development plans specify the objectives of increased private  sector development, strengthened education and training, and improved  public sector management as means of achieving the goals of budgetary  self-reliance and long-term economic growth. The amended compacts’  fiscal procedures agreements requires the JEMCO and JEMFAC to  monitor FSM and RMI progress toward their long-term development  objectives, however the oversight committees have not defined what  actions they will undertake to meet this requirement. At the fiscal year  2004 and 2005 annual JEMCO and JEMFAC meetings, as well as at a March  2006 JEMCO meeting, compact management committees focused on  approving sector grants and discussing grant administration issues. For  example, to approve the FSM health and education sector grants, JEMCO  has required supplementary information on health insurance programs  and that a certain amount of the FSM’s education grant is spent on  textbooks. The JEMCO meetings have not included discussion of FSM  progress toward its long-term development goals. At the 2005 JEMFAC  meeting, the RMI government provided a brief overview of GDP and  employment data, yet the presenting official reported that there was no  meaningful JEMFAC discussion of RMI long-term growth issues resulting  from the presentation. For example, while the RMI government presented  data on migration to the United States, JEMFAC did not discuss the  linkage between compact education spending and improving RMI  emigrant’s skills to encourage increased remittance income over the long-term. Through agency comments, HHS emphasized that an annualized  schedule for committee meetings does not provide enough frequency for  addressing both grant administration issues and long-term growth issues,  particularly given the relative lack of communication between JEMCO and  JEMFAC members in between meetings. HHS suggested that  communication be improved through periodic teleconference and  videoconference updates.
section_title: FSM and RMI Progress on Key Economic Policy Reforms Has Been Slow
paragraphs: FSM and RMI officials report that they have implemented a few legislation  actions to improve the private sector environment, such as bankruptcy  and mortgage laws, yet progress on key policy reforms required to  stimulate investment has been slow. According to FSM and RMI private  sector representatives as well as various U.S., IMF, ADB, and country  reports, an enabling business environment in either country requires  substantial reforms in taxes, land ownership, and foreign investment  regulations as well as a reduction in public sector competition with the  private sector. Despite several years of policy dialogue on taxes, the FSM  has agreed on elements of tax reform but has no plan for implementation  and the RMI has not agreed on structural change to its tax system. In  attempts to modernize complex, traditional land tenure systems, land  registration offices have been established in both countries; however, in  both countries, inadequate access to land and uncertainties over land  ownership and land values continue to create costly disputes,  disincentives for investment, and problems regarding the use of land as an  asset. Further, despite amendments to foreign investment regulations, the  regulations in both countries continue to be confusing and relatively  burdensome, according to economic experts and private sector  representatives. Finally, several years of public sector reform efforts have  also failed to reduce government involvement in private sector activities.  Thus far, the JEMCO and JEMFAC committees have not evaluated the lack  of FSM and RMI progress in implementing economic reforms to stimulate  investment and improve tax income, identified problems encountered or  recommended ways to improve assistance for these objectives.
subsections: section_title: FSM and RMI Have Implemented Some Legislative Reforms
paragraphs: Both the FSM and the RMI identified the need for economic reform within  their national development plans, and both countries have implemented or  are pursuing some legislative actions. For example, FSM officials report  that newly enacted legislation, although varying by state and national  government, include laws for bankruptcy, mortgages, long-term leases,  and secured transactions to allow movable assets to serve as collateral.
Some governments have also tried to improve foreign investment  processes or created small business development centers.
To create continued and strengthened demand for reform, the ADB has  also recently assisted both countries in holding several “Dialogue for  Action” retreats that enable public and private sector representatives to  develop a common vision for sustainable development through economic  reform. Our interviews with ADB and country participants suggested that  these retreats can be helpful for improving the public sector/private sector  dialogue on economic challenges facing each society. However, ADB  experts also emphasized that, in developing country commitment to  reform, the FSM and the RMI will need to overcome the “aid curse”—or  the distorted incentives for effective public sector management through,  e.g., public sector downsizing, which result from dependency on large  external aid flows.
section_title: Key Policy Reforms to Stimulate Investment Have Not Been Implemented
paragraphs: Despite several years of commitment to, and recommendations for, policy  reforms to stimulate investment in the FSM and the RMI, key reforms have  not yet been implemented. According to FSM and RMI private sector  representatives and a number of economic and country experts, policy  reforms are needed in the areas of tax, land, foreign investment, and the  public sector to improve business incentives and create an enabling  environment for domestic and foreign investment.
subsections: section_title: Tax Reform
paragraphs: Tax structures in the FSM and the RMI remain complex and unequal and  engender business disincentives.
The FSM tax system has been criticized by economic experts, the FSM  government, and the FSM private sector for (1) multiple taxation of the  same products (2) weak administrative collection, audit, and enforcement  capacity (3) taxation on a gross rather than net basis, and (4) duplicative  national and state tax administrations. Since 1994, the IMF and other  experts have recommended, among other tax reforms, implementing a  value-added tax (VAT), a simplified net profit tax, and a single modernized  independent tax authority. In 2005, the FSM Task Force on Tax Reform  developed a tax reform proposal, endorsed by the FSM President, that  included these principles. Nonetheless, despite the fact that such reforms  are estimated to require 2 to 3 years for implementation, the FSM  government has neither begun to implement the proposal nor specified an  implementation plan. Although the FSM government has made some  efforts to improve tax administration, actions by existing tax authorities in  the national government and each state government continue to exhibit  duplication and inefficiency.
The RMI government and economic experts have recognized for several  years that the RMI tax system is complex and regressive, taxing on a gross  rather than net basis and having weak collection and administration  capacity. The RMI stated in its comments to this report that their private  sector representatives’ most common complaint on the RMI tax system is  the need for better and tighter enforcement. The RMI Office of Tax and  Revenue reported that it has focused on improving tax administration and  has raised some penalties and tax levels. However, legislation for income  tax reform has failed and needed changes in government import tax  exemptions have not yet been addressed.
section_title: Land Reform
paragraphs: Inadequate access to land and uncertainties over land ownership and land  values continue to create costly land disputes, disincentives for  investment, and problems regarding the use of land as an asset in both the  FSM and the RMI.
Land tenure systems in each nation are complex and based on traditional  and customary rights, often for multiple individuals, such that most  parcels do not have a registered, legal title. Our interviews with FSM and  RMI officials and private sector representatives suggested that costly  boundary disputes are common.
Land values are also uncertain owing to the lack of a developed land  market or price data on lease transactions, such that banks are unable to  effectively conduct mortgage secured lending. Given that a major  proportion of FSM and RMI wealth lies in property, the inability to use it to  secure financing for development is problematic.
Using land for foreign investment in the FSM and the RMI is even more  difficult. Economic experts report that foreigners are prohibited from  owning land in both nations and are also unable to secure a valid lease  when land values or ownership is uncertain.
Land reform issues have been discussed in the FSM and the RMI for  several years, and land registration offices have been established.  However, such offices have lacked a systematic method for registering  parcels, instead waiting for landowners to voluntarily initiate the process.  Both the FSM and the RMI land registration offices reported that  landowners have shown little interest in land registration, partly owing to  the cultural issues associated with traditional land ownership structures.  In the RMI, for example, only 5 parcels have been, or are currently being,  registered by the land registration office. The functionality of land  registration offices in both the FSM and the RMI has also been limited by a  lack of registered surveyors and trained staff.
section_title: Foreign Investment Regulations
paragraphs: Although the FSM and the RMI have amended various aspects of their  foreign investment laws to streamline the process, the overall climate for  foreign investment remains complex and nontransparent, according to  economic experts and private sector representatives. In the FSM, experts  report that foreign investment regulations vary between states, creating  confusion and additional requirements for investors who want to invest in  several states. In both the FSM and the RMI, foreign investment  regulations remain relatively burdensome, with reported administrative  delays and difficulties in obtaining permits for foreign workers. According  to an Interior official, a shipping company with service from the U.S. West  Coast to Guam has for years been seeking permission to provide shipping  service to the FSM and the RMI but has consistently been refused entry by  those nations. The climate for foreign investment is also reportedly  affected by private and public interests’ protecting local businesses from  foreign competition. For example, experts report that foreign investment  is restricted from some industries in both the FSM and the RMI, and some  FSM states require a certain percentage of local ownership in foreign  investment. Pohnpei state, for instance, requires 30 percent local  ownership for foreign investment and prohibits foreign activity in retail,  according to its Foreign Investment Board. Interviews with country  officials, private sector representatives, and an ADB expert also suggest  that local businesses sometimes lobby the foreign investment boards  against approval of certain applications.
section_title: Public Sector Reform
paragraphs: Extensive FSM and RMI government involvement in commercial activities  continues to hinder private sector development, owing to high public  sector wages and government enterprises that directly compete with  private industry. The FSM’s and the RMI’s public sector reform efforts  since the 1990s have been based on restructuring government operations  to (1) reduce the size and cost of the civil service, (2) reduce government  involvement in market-oriented enterprises that could be more efficiently  operated by the private sector, and (3) improve government provision of  critical support services. One example of a reform success highlighted by  economic experts is the RMI’s restructuring of its Social Security  Administration to reduce operating costs and improve service provision.  However, despite government endorsement of public sector reform  principles, early efforts to reduce public sector employment have  generally failed in both the FSM and the RMI, and the share of public  sector employment has increased over the past few years. FSM and RMI  public sector wages also remain about twice the level of private sector  wages, contributing to the large government wage bill and effectively  drawing the most skilled employees out of the private sector into public  sector jobs. In addition, the FSM and the RMI governments continue to  conduct a wide array of commercial enterprises that compete with private  enterprises, although the share of employment accounted for by these  enterprises, as well as estimated direct public enterprise subsidies, has  declined in recent years (see table 4).
Nonetheless, IMF and ADB officials expressed concern that the FSM and  the RMI governments are not committed to reducing their participation in  commercial activities, despite the fact that most of the enterprises have  drained public finances through poor financial performance, requiring  subsidization or entailing debt (see examples in table 4). In conjunction  with the ADB, the FSM prepared a comprehensive program for public  sector enterprise reform in 1999 that identified two enterprises per state  and national government for privatization (such privatizations later  became a condition for receiving ADB loan assistance) and entailed plans  for the creation of a Public Sector Enterprise Unit. This unit has not yet  been fully staffed, and the ADB loan requirement was reduced to one  enterprise per state and national government, a condition that has not yet  been met. The RMI has yet to prepare a comprehensive policy for public  enterprise reform. Our interviews with economic experts and FSM and  RMI officials suggested that although they plan to privatize some public  enterprises, they intend to expand others.
section_title: Compact Management Committees Have Not Addressed Slow FSM and RMI Progress in Implementing Reforms
paragraphs: To date, JEMCO and JEMFAC have not addressed the lack of FSM and  RMI progress in implementing reforms that their development plans  specify are needed to stimulate investment and improve tax income.  Different from the original compact, the legislation implementing the  amended compacts specifically directs the JEMCO and JEMFAC to  address FSM and RMI policy reforms by (1) evaluating progress in  implementing these policy reforms, (2) identifying problems encountered,  and (3) recommending ways to increase the effectiveness of U.S.  assistance. In the 2004 and 2005 JEMCO and JEMFAC meetings, as well  as in a 2006 JEMCO meeting, compact management committees focused  on grant approval and administration and did not address the status of  reforms or include discussions of how compact grant assistance could be  leveraged to improve the policy environment for private sector growth and  investment. Specifically, compact management committees did not  discuss the lack of FSM and RMI progress in tax, land, foreign investment,  or public sector reform; factors that contributed to this lack of progress; or  the interdependence of policy reform implementation with effective  compact grant implementation. Opportunities exist to create linkages  between grant administration and economic reforms. For example, sector  grants in public sector capacity building could be used to address capacity  constraints that have been identified as an obstacle to reform  implementation (e.g., the lack of certified land surveyors for land reform).  Further, compact management committees could establish linkages  between, for example, grants to tourism promotion agencies and progress  in reforming foreign investment regulations to improve the private sector  environment for investment or grants to private sector development  offices and progress in reforming public enterprises that compete with  private industry.
section_title: Conclusions
paragraphs: The FSM and the RMI face notable challenges to achieving budgetary self- reliance and long-term economic advancement, given their current health  and education hardships; dependence on grant assistance; and need to  effect reforms that are often politically, culturally, and technically difficult  to implement. Tax, land, foreign investment regulation and public-sector  reforms, when implemented, will improve the business environment, in  turn facilitating the private sector expansion that may help the countries  advance their compact goals. However, even with the needed reforms,  growth in the FSM’s and the RMI’s private sectors may be limited by  structural constraints such as geographic isolation and high transport  costs. As a result, the FSM and the RMI may need to expand economic  activities beyond their borders—including, as some experts suggest,  expanding remittance income by equipping emigrants with better skills  and, therefore, stronger income-earning opportunities abroad.
Because the amended compacts have been in place for only a few years, it  is difficult to determine whether the assistance they provide will  contribute to the fundamental changes in FSM and RMI economic  structures and institutions necessary to achieve budgetary self-reliance  and economic advancement. Expanding FSM and RMI private sector  activity and remittance income will require effective compact grant  implementation, just as successful compact grant implementation will  require FSM and RMI commitment to policy reform. The scheduled  coming reductions in U.S. grants to both countries create urgency for the  implementation of policy reforms if they require fiscal resources and for  capitalizing on opportunities to leverage compact assistance to improve  social and economic conditions through reform.
section_title: Recommendations
paragraphs: To maximize FSM and RMI potential for budgetary self-reliance and long- term economic advancement, we recommend that the Secretary of the  Interior direct the Deputy Assistant Secretary for Insular Affairs, as  Chairman of JEMCO and JEMFAC, to ensure—in coordination with other  U.S. agencies participating in these committees—that they fulfill their  requirements in the following three areas:    evaluate FSM and RMI progress in implementing policy reforms needed to  improve the business environment and encourage increased investment  and tax income, identify problems encountered with policy reform implementation, and  recommend ways to improve U.S. assistance for these objectives.
section_title: Agency Comments
paragraphs: We received comments from the Departments of the Interior and HHS, as  well as from the FSM and the RMI. A more detailed presentation and  response to the comments can be found in appendixes IV through VII. We  also received technical comments from Interior, State, Treasury, HHS and  the RMI. We incorporated technical comments into our report, as  appropriate.
The Department of Interior concurred with our recommendation and  stated that it is pursuing additional information on the FSM and the RMI  economies to support its implementation of the recommendation. The RMI  advocated for JEMFAC support in policy reform implementation and  emphasized that public sector reforms are particularly vital. HHS also  agreed with our recommendation and requested that it be expanded to  include JEMCO and JEMFAC requirements for establishing timelines for  policy reform implementation. While establishing timelines is not a  requirement under the amended compact or its subsidiary agreements, we  encourage the JEMCO and JEMFAC to consider this idea as one method to  improve U.S. assistance in support of an improved FSM and RMI  environment for investment and tax income. Further, Interior, HHS, and  the FSM emphasized that the JEMCO and JEMFAC have thus far focused  their attention on accountability issues and problems that have arisen  within the various sector grants. HHS suggested that, in order to ensure  the JEMCO and JEMFAC can address all pertinent short-term and long- term issues, mechanisms to improve communication and information  between annual meetings—such as periodic teleconferences and  videoconferences—should be pursued. The FSM viewed the report as a  potentially constructive contribution to ongoing efforts to pursue  budgetary self-reliance and economic advancement, yet disagreed with our  conclusion that FSM development prospects remain limited.
In addition to providing copies of this report to your offices, we will send  copies of this report to other appropriate committees. We will also provide  copies to the Secretaries of the Interior, State, and Health and Human  Services, as well as the President of the Federated States of Micronesia  and the President of the Republic of the Marshall Islands. We will make  copies available to other interested parties upon request.
If you or your staff have any questions regarding this report, please  contact me at (202) 512-3149 or gootnickd@gao.gov. Contact points for our  Offices of Congressional Relations and Public Affairs may be found on the  last page of this report. GAO staff who made major contributions to this  report are listed in appendix VIII.
section_title: Appendix I: Objectives, Scope, and Methodology
paragraphs: The amended compacts implementing legislation requires that we report  on political, social, and economic conditions in the Federated States of  Micronesia (FSM) and the Republic of the Marshall Islands (RMI) as well  as the use and oversight of U.S. assistance to those nations. In compliance  with the legislation’s requirement, this report examines each country’s (1)  political and social environment for compact grant implementation; (2)  economic conditions, including overall growth, fiscal balances, and private  investment; and (3) status of economic policy reforms.
To identify key aspects of the FSM and the RMI political and social  environment for compact grant implementation, we reviewed the U.S.,  FSM, and RMI annual compact reports for 2004; U.S. Department of State  reports on FSM and RMI political systems and human rights practices;  political assessments by nongovernmental organizations such as  Transparency International and the University of Hawaii; and information  from the Pacific Islands Forum regarding FSM and RMI participation in  regional agreements and organizations. We identified key areas of  concern in delivery of health and education services by reviewing FSM and  RMI development plans, and reports prepared in conjunction with the  Asian Development Bank (ADB), the World Bank, or the United Nations  Development Program. We obtained FSM and RMI socioeconomic  statistics on noncommunicable diseases, access to safe water and  sanitation, teacher certifications and literacy skills, and Pacific Island  Literacy Level student test scores from the FSM Departments of Health  and Education and the RMI Ministries of Health and Education. We  obtained regional socioeconomic statistics on population trends, teenage  fertility, child mortality rates, immunizations, human poverty, and GDP  and aid per capita from the World Bank’s World Development Indicators,  the U.S. Census International Database, and the 2005 United Nations  Human Development Report.
To assess FSM and RMI economic conditions, we reviewed the U.S., FSM,  and RMI annual compact reports for 2004; FSM and RMI development  plans; recent International Monetary Fund (IMF) Article IV documents for  each nation; ADB Country Strategies and Program Updates; 2005 FSM and  RMI Pacific Island Economic Reports (PIER) prepared in conjunction with  the ADB; and expert reviews of FSM and RMI fiscal structures and tax  systems. We obtained data on FSM and RMI economic indicators such as  gross domestic product (GDP), employment, government finances,  migration, and private sector development from the IMF; the FSM’s 2005  Statistical Tables; the RMI’s 2004 Annual Yearbook and 2005 Employment  Statistics; the OECD’s international development statistics; the U.S.  Department of Census; and the World Bank’s World Development  Indicators.
To describe the status of economic policy reforms in the FSM and the RMI,  we reviewed the documents mentioned above; the FSM Tax Reform Task  Force 2005 Report to the President; the RMI 2005 Budget Statement; ADB  progress reports on the RMI Private Sector Development Project and the  FSM Private Sector Development Loan; and RMI Final Reports from the  2005 Dialogue For Action Retreats sponsored by the ADB. We obtained  data on FSM and RMI public sector enterprises from the FSM’s 2005  Statistical Tables; the RMI’s 2004 Annual Yearbook; and the most recent  available public enterprise audit reports.
In addition, we held extensive interviews with officials from the U.S.  Department of the Interior (Washington, D.C.; Honolulu; the FSM; and the  RMI) and the Department of State (Washington, D.C.; the FSM; and the  RMI). We also interviewed officials from the U.S. Departments of Treasury  and Health and Human Services (Washington, D.C., and Honolulu) and  experts from the ADB (Manila, the Philippines), the IMF (Washington,  D.C.), the World Bank (Washington, D.C.) and the Pacific Islands  Development Program at the East-West Center (Honolulu). We traveled to  all four states in the FSM and to the RMI (Majuro). We met with the  governor’s and legislature’s offices in each of the FSM states and the  President’s office in the RMI. We had detailed discussions with FSM  (national and state governments) and RMI officials from foreign affairs,  finance and budget, economic affairs, health, education, land management,  tourism and fisheries, environmental protection, and audit agencies. In  each location, we also met with numerous representatives from private  sector businesses, banks, and community organizations.
To ensure accuracy in our report, we asked experts at the ADB, the IMF,  the World Bank, the Boston Institute of Development Economics, and the  University of Hawaii’s East-West Center with knowledge of the FSM and  the RMI economies, as well as former members of the FSM’s Economic  Management and Policy Advisory Team, to provide a technical review of  our findings and information on the reliability of data used to support  those findings. In conjunction with our own assessment, we determined  that trade data, remittance data, and data on the private sector profits  contained weaknesses. Exact data for these elements were not presented  in the report and related findings were corroborated with other reliable  data. For other social and economic data included in the report, we  determined they are sufficiently reliable for our purposes.
Nonetheless, our interviews with U.S., country, and international officials  revealed important constraints to the FSM’s and the RMI’s capacity to  prepare regular, reliable, and complete data that would allow for a more  thorough analysis of social and economic trends, particularly in the future.  Trend data on a variety of social indicators, such as teacher qualifications  and student drop-outs, could assist in evaluation of the effectiveness of  compact education assistance. However, much of this data are just now  being collected in a systematic way. Also, given that both nations have  weak domestic capacity to produce statistics, they rely heavily on external  consultants for this purpose. In the FSM, the contract for statistical  assistance from external consultants has now expired. As such, both FSM  and Interior officials have expressed concern for that nations’ capacity to  produce future statistics.
We conducted our review from August 2005 through March 2006 in  accordance with generally accepted U.S. government auditing standards.  We requested written comments on a draft of this report from the  Departments of the Interior, State, Health and Human Services, and  Treasury, as well as the governments of the FSM and the RMI. All  comments are discussed in the report and are reprinted in appendixes IV  through VII. Further, we considered all comments and made changes to  the report, as appropriate.
section_title: Appendix II: Some Regional Socioeconomic Data for the Pacific
paragraphs: Economic studies of small island economies suggest common challenges  for socioeconomic development. According to international development  organizations, developing nations in the Pacific have exhibited relatively  poor economic performance and face common constraints to growth such  as geographic isolation and high transport costs. Such nations have also  exhibited the need for improvements in delivery of health and education  services, a challenge heightened when youths account for a large share of  the population. Environmental challenges from climate change and  increasing population density are also common threats to ensuring  sustainable livelihoods in the Pacific. Table 5 provides estimated  socioeconomic data on various Pacific island nations in order to illustrate  some of these commonalities as well as areas where the FSM and the RMI  characteristically differ. For example:    The RMI has a relatively small population, but both the RMI and the FSM  have a relatively large population density at 331 and 181 people per square  kilometer, respectively. The RMI also has a very high teenage fertility rate.
Except for Palau—also a nation with a Compact of Free Association with  the United States—the FSM and the RMI have the highest levels of aid per  capita.
The FSM’s child mortality rates are significantly lower than the RMI’s, and  its immunization rates are significantly higher. The RMI provides a  significantly higher proportion of the population access to improved  sanitation.
section_title: Appendix III: The FSM and RMI Private Sector Environment
paragraphs: Private sector representatives in the FSM and the RMI characterized the  business environment in their nation as obstructive and costly. They  attribute this characterization to elements of the political environment  (e.g., poor information), lack of progress in economic reforms (both legal  and financial), and poor government performance in providing services.  World Bank national business environment surveys suggest that a high  cost of doing business is a common problem for small island states.  However, the survey results show that FSM and RMI business  environments are particularly costly in several areas. For example, of 155  countries surveyed, the FSM and the RMI are among the worst 10 to 20  countries in terms of the cost of enforcing contracts and the degree of  investor protection. In interviews with private sector representatives,  problems were noted with FSM and RMI business environments (see fig.  7).
section_title: Appendix IV: Comments from the Department of the Interior
paragraphs: The following are GAO’s comments on the Department of the Interior  letter dated May 16, 2006.
subsections: section_title: GAO Comments
paragraphs: 1.  Regarding our finding that compact management committees have not  discussed FSM and RMI progress toward budgetary self-reliance and  long-term economic advancement at their annual meetings, we  recognize that the Deputy Assistant Secretary submitted a statement  for the record at the opening of the 2005 JEMCO meeting that  mentioned the lack of sustainability in the FSM’s economic  dependence on government expenditures. However, the Deputy  Assistant Secretary did not read his statement to the committee and  the issue of FSM progress toward their long-term development goals  was not discussed by the JEMCO.  2.  We recognize that Interior has contracted with the U.S. Department of  Agriculture’s Graduate School to obtain further economic information  on the FSM and the RMI. While we agree with the importance of  gaining this further information, we believe that sufficient information  is available for the committees to begin meeting their requirement to  evaluate FSM and RMI progress in implementing reforms, identify  problems encountered, and recommend ways to improve U.S.  assistance for these objectives. For example, multiple expert studies as  well as FSM and RMI commitment to, and recommendations for policy  reforms in the areas of tax, land, foreign investment, and the public  sector have existed since the 1990s.
section_title: Appendix V: Comments from the Department of Health and Human Services
paragraphs: The following is GAO’s comment on the Department of Health and Human  Services letter dated May 23, 2006.
subsections: section_title: GAO Comment
paragraphs: HHS agreed with our recommendation and requested that it be expanded  to include JEMCO and JEMFAC requirements for establishing policy  reform implementation timelines. The amended compacts’ U.S.  implementing legislation does not include establishing timelines for policy  as a specific required action for the JEMCO and JEMFAC. Nonetheless, in  fulfilling their requirement to identify problems encountered with policy  reform implementation and recommend ways to improve U.S. assistance,  the JEMCO and JEMFAC should consider this suggestion. As noted in our  conclusions and by HHS, the urgency of pursuing policy reform suggests  that establishing timelines for such reforms could be a useful method to  improve U.S. assistance. We also appreciate HHS’s suggestion to improve  communication and information between annual meetings through  periodic teleconferences and videoconferences and have added language  to the report to reflect this suggestion. We have also added language to the  report recognizing HHS’s efforts to improve vaccine coverage.
section_title: Appendix VI: Comments from the Federated States of Micronesia
paragraphs: The following is GAO’s comment on the Federated States of Micronesia  letter dated May 30, 2006.
subsections: section_title: GAO Comment
paragraphs: Regarding the FSM’s disagreement with our conclusion that its  development prospects remain limited—the FSM confirms the accuracy of  our description of its recent economic performance, its constraints to  growth, and its need for economic policy reforms. Given these current  realities, we maintain that prospects for long-term economic growth in the  FSM remain limited. We do not assert, however, that economic  development cannot be attained. If key policy reforms were implemented,  the business environment would likely improve and facilitate private  sector expansion that may help the FSM advance its compact goals.  Further, we agree that implementation of policy reforms will not, in of  itself, produce economic development. As such, the FSM will also likely  need to identify and capitalize on niche market opportunities as well as to  create conditions to maximize remittance income, particularly through  improving the education and health of its citizens. Establishing  connections with the overseas business community may be one way to  pursue such opportunities and should be included in meaningful JEMCO  discussions of FSM progress toward their economic goals. As we  emphasized earlier, the scheduled coming reductions in U.S. grants creates  urgency for implementation of policy reforms and for capitalizing on  opportunities to leverage compact assistance. The coming reductions in  U.S. grants, paired with current economic realities, also suggests the need  for JEMCO discussions to be based on frank assessments of current  limited prospects for economic growth in the FSM and what actions need  to be pursued to improve those options.
section_title: Appendix VII: Comments from the Republic of the Marshall Islands
paragraphs: The following are GAO’s comments on the Republic of the Marshall  Islands letter dated June 1, 2006.
subsections: section_title: GAO Comments
paragraphs: 1.  Regarding our recommendation, we believe that economic reforms in  each of the areas discussed (e.g., tax, land, foreign investment, and  public sector) are needed to improve the RMI’s prospects for long-term  economic growth and have clarified the report language. We also agree  that the annual decrement in compact grant funding is a major  challenge to achieving this objective, particularly if implementation of  key policy reforms requires fiscal resources.  2.  We recognize that the FSM and the RMI were required under the  amended compacts to contribute an initial $30 million to their trust  funds. Recent RMI GDP performance may have differed if this funding  were used to provide current goods and services rather than for  savings. Nonetheless, the RMI’s contribution to their trust fund does  not alter the extent of RMI economic dependence on external  assistance. Our description of RMI economic performance was also  based on broad trends from 2000 to 2005, rather than exclusively on  the 2 years of bump-up assistance in 2002 and 2003.  3.  We will address amended compact implementation issues and trust- fund issues in two separate reports, forthcoming. We have also added  language to this report indicating the RMI’s concern over delays in  setting up its trust fund.  4.  We have clarified our estimates and figures with regards to funding  streams they include and exclude. Section 177 funds are not included  in our analysis.  5.  Section 211 of Title Two of the Amended Compact with the RMI states  that compact grants shall be used for assistance in education, health  care, the environment, public sector capacity building, and private  sector development, or for other areas as mutually agreed, with  priorities in the education and health sectors.  6.  We have added language regarding RMI consultations with the private  sector and their desire for improved tax enforcement. The  effectiveness of U.S. and ADB technical assistance to the RMI is  outside the scope of this report. We note, however, that the RMI  allocated no compact funding to a public sector capacity building grant  in fiscal year 2004 and less than 1 percent of compact sector grant  funding to such a grant in fiscal year 2005.  7.  We discuss remittances in our report as one option that the RMI may  consider in pursuing the economic goals under the amended compact  and that the JEMFAC may consider when discussing compact grant  implementation. In the RMI’s METO 2000 Statement of Development  Strategies and its 2001 Strategic Development Plan entitled “Vision  2018,” the RMI estimates that between 500 to 800 new job entrants will  need to find employment each year from 1999 to 2009. To meet this  objective, the ready access provided under the compact for  Marshallese to live and work in the U.S. must be preserved. These  documents also emphasize that the education system needs to equip  Marshallese to succeed both in the RMI and abroad. Economic experts  have emphasized that the RMI’s free access and strong historical links  to the U.S. market provide the RMI with relatively good opportunities  to expand remittance income, particularly if migrants had upgraded  skills. Improved skill provision should benefit both RMI emigrants as  well as domestic economic prospects.  8.  We have clarified our reference that 2003 data on international visitor  arrivals are for other Pacific island nations. Such data are not available  for Kiribati and Nauru. The World Bank has estimated that, in 2002,  Kiribati had 5,000 international visitors. However, Kiribati also has a  per capita GDP that is less than one-third of the RMI’s.  9.  RMI employment data indicate that the RMI did succeed in reducing  public sector employment from about 3,760 jobs in 1997 to about 3,530  jobs in 2001. However, since then, public sector employment has risen  to about 4,320 jobs in 2005.  10. We have modified language in the report to clarify each of these points.
We have added language to the report to include the volatility in tax  income from the fisheries and tourism sectors and the fact that RMI  offices related to reform efforts, such as land registration offices, have  been funded with compact grants.
section_title: Appendix VIII: GAO Contact and Staff Acknowledgments
subsections: section_title: GAO Contact
section_title: Staff Acknowledgments
paragraphs: In addition to the persons named above, Emil Friberg, Assistant Director;  Leslie Holen; Reid Lowe; Mary Moutsos; Kendall Schaefer; and Seyda  Wentworth made key contributions to this report.
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