Palau consists of 8 main islands and more than 250 smaller islands, with a total land area of roughly 190 square miles, located approximately 500 miles southeast of the Philippines. About 20,000 people live in Palau, concentrated largely in one urban center around the city of Koror, and more than one-quarter of the population is non-Palauan. Palau’s economy is heavily dependent on its tourism sector and on foreign aid from the United States, Japan, and Taiwan. Similar to many small island economies, Palau’s public sector spending represents a significant percentage of its gross domestic product (GDP). U.S. relations with Palau began when American forces liberated the islands near the end of World War II. In 1947, the United Nations assigned the United States administering authority over the Trust Territory of the Pacific Islands, which included what are now the Federated States of Micronesia, the Republic of the Marshall Islands, the Commonwealth of the Northern Mariana Islands, and Palau. Palau adopted its own constitution in 1981. The U.S. and Palau governments concluded a Compact of Free Association in 1986; the compact entered into force on October 1, 1994. The Department of the Interior’s (Interior) Office of Insular Affairs (OIA) has primary responsibility for monitoring and coordinating all U.S. assistance to Palau, and the Department of State (State) is responsible for government-to-government relations. Key provisions of the compact and its subsidiary agreements address the sovereignty of Palau, types and amounts of U.S. assistance, security and defense authorities, and periodic reviews of compact terms. Table 1 summarizes key provisions of the Palau compact and related subsidiary agreements. In addition to the U.S. assistance provided under the compact, U.S. agencies—the Department of Education, the Department of Health and Human Services (HHS), and Interior, among others—provide discretionary federal programs in Palau as authorized by U.S. legislation and with appropriations from Congress. (See app. II for a complete listing of these programs in Palau.) In our 2008 report, we projected that U.S. assistance to Palau from 1995 through 2009 would exceed $852 million. Of this total, economic assistance under the compact accounts for a projected 68 percent and discretionary federal programs account for a projected 31 percent (see fig. 1). The September 2010 Agreement between the U.S. and Palau governments would extend assistance to Palau to 2024 but steadily reduce the annual amount provided. The Agreement would also extend the authority and framework for U.S. agencies to continue compact federal services and discretionary federal programs. Key provisions of the Agreement would include, among others, extending direct economic assistance to Palau, providing infrastructure project grants and contributions to an infrastructure maintenance fund, establishing a fiscal consolidation fund, and making changes to the trust fund. U.S. assistance to Palau under the Agreement would total approximately $215 million through 2024. Legislation implementing the Agreement was not approved by Congress during 2011. Department of the Interior provided $13.1 million for direct economic assistance in 2011 and again in 2012; however, funds were not provided either year for infrastructure projects, the infrastructure maintenance fund, or the fiscal consolidation fund.  Direct economic assistance ($107.5 million). Under the Agreement, the U.S. government would provide direct economic assistance— budgetary support for Palau government operations and specific needs such as administration of justice and public safety, health, and education—amounting to $13 million in 2011 and declining to $2 million by 2023. The Agreement also calls for the U.S. and Palau governments to establish a five-member Advisory Group to provide annual recommendations and timelines for economic, financial, and management reforms. The Advisory Group must report on Palau’s progress in implementing these or other reforms, prior to annual U.S.- Palau economic consultations. These consultations are to review Palau’s progress in achieving reforms such as improvements in fiscal management, reducing the public sector workforce and salaries, reducing government subsidization of utilities, and tax reform. If the U.S. government determines that Palau has not made significant progress in implementing meaningful reforms, direct assistance payments may be delayed until the U.S. government determines that Palau has made sufficient progress. Infrastructure projects ($40 million). Under the Agreement, the U.S. government would provide U.S. infrastructure project grants to Palau for mutually agreed infrastructure projects—$8 million annually through 2013, $6 million in 2014, and $5 million in both 2015 and 2016. The Agreement requires Palau to provide a detailed project budget and certified scope of work for any projects receiving these funds. Infrastructure maintenance fund ($28 million). Under the Agreement, the U.S. government would make contributions to a fund to be used for maintenance of U.S.-financed major capital improvement projects, including the Compact Road and Airai International Airport. Through 2024, the U.S. government would contribute $2 million annually, and the Palau government would contribute $600,000 annually to the fund.  Fiscal consolidation fund ($10 million). Under the Agreement, the U.S. government would provide grants of $5 million each in 2011 and 2012, respectively, to help the Palau government reduce its debts. Unless agreed to in writing by the U.S. government, these grants cannot be used to pay any entity owned or controlled by a member of the government or his or her family, or any entity from which a member of the government derives income. U.S. creditors must receive priority, and the government of Palau must report quarterly on the use of the grants until they are expended.  Trust fund ($30.25 million). Under the Agreement, the U.S. government would contribute $30.25 million to the fund from 2013 through 2023. The government of Palau will reduce its previously scheduled withdrawals from the fund by $89 million. From 2024 through 2044, Palau can withdraw up to $15 million annually, as originally scheduled. Moneys from the trust fund account cannot be spent on state block grants, operations of the office of the President of Palau, the Olibiil Era Kelulau (Palau National Congress), or the Palau Judiciary. Palau must use $15 million of the combined total of the trust fund disbursements and direct economic assistance exclusively for education, health, and the administration of justice and public safety. Annual U.S. assistance to Palau under the Agreement would decline from roughly $28 million in 2011 to $2 million in 2024. Figure 2 details the timeline and composition of assistance outlined in the Agreement. The Agreement would extend the authority for the provision of compact federal services and discretionary programs in Palau.  Federal services. The Agreement would amend the compact’s subsidiary agreements regarding federal services. Specifically, the Agreement amends the terms of postal, weather, and aviation services to Palau.  Federal discretionary programs. The Agreement would extend the framework for U.S. agencies to provide discretionary federal programs to Palau, with implementation of the programs contingent on annual appropriations to those agencies. The addition of $30.25 million in U.S. contributions and the delay of $89 million in Palau withdrawals through 2023, as provided by the Agreement, would improve the fund’s prospects for sustaining scheduled payments through 2044. At the end of June 2012, the fund had a balance of approximately $163 million. The trust fund would need a 5.0 percent annual return to yield the proposed withdrawals from 2011 through 2044 under the Agreement. This rate is well below the 7.9 percent return that the fund earned from its inception to June 30, 2012. Figure 3 shows projected trust fund balances in 2012 through 2044 under the Agreement, with varying rates of return. The additional contributions and reduced withdrawals scheduled in the Agreement would also make the trust fund a more reliable source of revenue under conditions of market volatility. With these changes, the trust fund would have an approximately 90 percent probability of sustaining payments through 2044. In comparison, the fund has a 40 percent probability of sustaining the $15 million annual withdrawals scheduled under the compact through 2044. Figure 4 compares the probability that the trust fund will sustain the proposed withdrawals under the terms outlined in the Agreement with the probability that the trust fund will sustain the withdrawals scheduled under the compact. Estimates prepared for the government of Palau project that Palau’s reliance on U.S. assistance provided under the Agreement will decline, while its reliance on trust fund withdrawals and domestic revenue will increase. These estimates show U.S. assistance, as provided under the Agreement, declining from 28 percent of government revenue in 2011 to less than 2 percent of government revenue in 2024. The estimates also show Palau’s trust fund withdrawals growing from 5 percent of government revenue in 2011 to 12 percent in 2024. In addition, the estimates indicate that Palau’s domestic revenue will rise from 40 percent of all government revenue in 2011 to 59 percent in 2024. Finally, the estimates prepared for Palau project a relatively steady reliance on U.S. discretionary federal programs, ranging from 12 percent of all government revenue in 2011 to 14 percent in 2024. The estimates assume that discretionary federal programs will grow at the rate of inflation; however, discretionary programs are subject to annual appropriations and may not increase over time. Figure 5 shows the types and amounts of Palau’s estimated revenues for 2011 and 2024. The estimates prepared for the government of Palau project that U.S. assistance to Palau from 2011 through 2024, including discretionary federal programs, will total approximately $427 million. The estimates further project that discretionary programs will account for nearly half of U.S. assistance through 2024, with assistance amounts specified in the Agreement accounting for the other half. (See fig. 6.) In contrast, in 2008, we estimated discretionary program funding accounted for less than one- third of total U.S. assistance to Palau from 1995 through 2009. Legislation has been introduced in both the Senate and the House that would approve and implement the September 2010 agreement between the U.S. and Palau governments. In February 2011, a bill was introduced in the Senate that would implement the Agreement, as written. The Senate bill would authorize and appropriate funds to Interior for specified assistance. The Senate bill would also extend the authority, and authorize appropriations, for the provision of compact federal services in Palau. However, the proposed legislation does not appropriate funds for compact federal services. As of September 2012, the Senate has not acted on this bill. In June 2012, a bill was introduced in the House that would approve and implement the Agreement, with some modifications. Specifically, the pending House bill:  Shifts the timing of the provision of some specified Agreement assistance to account for the fact that fiscal year 2011 has passed.  Extends the full faith and credit provision of the compact to the U.S. commitments of assistance under the Agreement for direct economic assistance, the trust fund, the infrastructure maintenance fund, the fiscal consolidation fund, and infrastructure projects.  Applies an inflation adjustment to the Agreement assistance for direct economic assistance and infrastructure project grants, and payments to the trust fund, infrastructure maintenance fund, and fiscal consolidation fund.  Extends a pledge of the full faith and credit of the United States for the full payment of the amounts necessary to conduct the audits of the assistance provided, as called for under the Agreement. In addition, the Senate and House bills implementing the Agreement would amend the sections of the Agreement that extend the authority for the provision of compact federal services and discretionary programs in Palau. The proposed Senate and House legislation would authorize annual appropriations for weather and aviation services. The proposed Senate and House legislation would extend the eligibility of the people, government, and institutions of Palau for certain discretionary programs, including special education and Pell grants. However, the proposed bills differ in how they would authorize appropriations to subsidize postal service to Palau, the Republic of the Marshall Islands, and the Federated States of Micronesia. The Senate legislation would have authorized appropriations of $1.5 million to Interior for 2011 through 2024, to subsidize postal services provided by the U.S. Postal Service. The proposed House legislation would authorize appropriations of $1.5 million to Interior beginning in 2012 and through 2024, to subsidize postal services. Under the proposed House bill, Interior would be authorized to transfer these funds to the U.S. Postal Service under the condition that domestic postage may be used for mail to these countries. Chairman Fleming, Ranking Member Sablan, and Members of the Subcommittee, this completes my prepared statement. I would be happy to respond to any questions you may have at this time. For further information about this statement, please contact David Gootnick 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 statement. Emil Friberg (Assistant Director), Ming Chen, David Dayton, Brian Hackney, Reid Lowe, Grace Lui, and Valérie L. Nowak made key contributions to this statement. Robert Alarapon, Benjamin Bolitzer, Rhonda Horried, Farahnaaz Khakoo, Jeremy Sebest, Cynthia Taylor, and Anu Mittal provided technical assistance. Table 2 shows the assistance provided to Palau under the compact from 1995 through 2009. Table 3 shows the proposed assistance to Palau for 2011 through 2024, as outlined in the Agreement. Table 4 lists discretionary U.S. federal program funds expended by the Palau national government, the Palau Community College, and the Palau Community Action Agency, as reported in the organizations’ single audit reports for 2009.

Summary: The Compact of Free Association between the United States and the Republic of Palau, which entered into force in 1994, provided for several types of assistance aimed at promoting Palaus self-sufficiency and economic advancement. Included were 15 years of direct assistance to the Palau government; contributions to a trust fund meant to provide Palau $15 million each year in fiscal years 2010 through 2044; construction of a road system, known as the Compact Road; and federal services such as postal, weather, and aviation. U.S. agencies also provided discretionary federal programs related to health, education, and infrastructure. In 2008, GAO projected that total assistance in fiscal years 1994 through 2009 would exceed $852 million. In September 2010, the United States and Palau signed an agreement (the Agreement) that would, among other things, provide for additional assistance to Palau beginning in fiscal year 2011 and modify its trust fund. Currently, there are two bills pending before Congress to implement the Agreement. In this testimony, GAO updates a November 2011 testimony on (1) the Agreements provisions for economic assistance to Palau, (2) its impact on the trust funds likelihood of sustaining scheduled payments through fiscal year 2044, (3) the projected role of U.S. assistance in Palau government revenues, and (4) the pending legislation to implement the Agreement. GAO reviewed current trust fund data and new pending legislation for this testimony. The Agreement would provide decreasing assistance, totaling approximately $215 million through fiscal year 2024 and includes the following: direct economic assistance ($107.5 million) for Palau government operations; infrastructure project grants ($40 million) to build mutually agreed projects; infrastructure maintenance fund ($28 million) for maintaining the Compact Road, Palaus primary airport, and certain other major U.S.-funded projects; fiscal consolidation fund ($10 million) to assist Palau in debt reduction; and trust fund contributions ($30.25 million) in addition to the $70 million contributed under the compact Under the Agreement, the United States would contribute to the trust fund in fiscal years 2013 through 2023, and Palau would reduce its withdrawals by $89 million in fiscal years 2010 through 2023. GAO projects that the fund would have a 90 percent likelihood of sustaining payments through fiscal year 2044 with these changes, versus 40 percent without these changes. Estimates prepared for the Palau government project declining reliance on U.S. assistance under the Agreementfrom 28 percent of government revenue in fiscal year 2011 to 2 percent in fiscal year 2024and growing reliance on trust fund withdrawals and domestic revenues. The estimates show trust fund withdrawals rising from 5 percent to 24 percent and domestic revenues rising from 40 to 59 percent, of total government revenue. According to the estimates, U.S. assistance in fiscal years 2011 through 2024 would total $427 million, with discretionary federal programs accounting for about half of that amount. Congress has not approved legislation to implement the Agreement as of September 2012. Pending Senate legislation would implement the Agreement and appropriate funds to do so. Pending House legislation would implement the agreement, apply an inflation adjustment to assistance payments, and shift the timing of certain assistance payments to reflect the fact that 2011 has passed.