Many of the 62 million people living in over 2,300 rural counties in the United States lack access to a supply of clean water and sanitary waste disposal facilities. In 1937, the Congress created a program that provided low-cost loans to ranchers, farmers, and rural residents of 17 arid and semiarid western states for water storage projects. Since that time, the Congress has changed the program to also fund water distribution systems and waste disposal facilities and to provide grant funds in addition to loans. Currently, the program, known as the Water and Waste Disposal Program, offers grants and loans to construct or modify water and/or sewer systems in rural communities that cannot obtain funding from other sources. Administered by the U.S. Department of Agriculture (USDA), this program is now the major federal program providing such loan and grant funds to rural America. USDA administers the Water and Waste Disposal Program—referred to in this report as the water and sewer program—through its Rural Utilities Service. To be eligible for this program, a rural community must have a population of 10,000 or less and be financially needy, meeting low-income criteria. USDA headquarters allocates both loan and grant funds to its state offices through an allocation formula that it established through regulations. The formula consists of three weighted factors: rural population (50 percent), rural poverty (25 percent), and rural unemployment (25 percent). No state may receive more than 5 percent of the total loan and grant funds initially allocated. About 10 percent of both loan and grant funds are set aside in a reserve pool for emergencies, cost overruns, and other unforeseen problems. Furthermore, twice a year, USDA headquarters withdraws to its reserve pool a portion of the unobligated loan and grant funds that may remain in a state’s accounts. State offices can request pooled funds and receive funding above a state’s initial allocation; USDA headquarters determines how pooled funds will be distributed. Generally, these pooled funds are used to provide supplemental funding for projects that are ready to be approved. In the following fiscal year, the states receive their allocations on the basis of the formula, not on whether they spent the prior year’s allocation. In fiscal year 1995, USDA headquarters withdrew about $60 million in loan and grant funds as a result of the pooling process. The water and sewer program has been funded at an average of $1 billion per year for the last 6 fiscal years; funding in fiscal year 1994 was about $1.3 billion. USDA administers the water and sewer program through a network of state and district offices. USDA headquarters allocates the program’s funds to the state offices, which are responsible for general oversight of the program, including approval of district offices’ project and funding recommendations. District offices administer the loan and grant program at the local level and serve as the point of contact for communities seeking assistance. Through a preapplication process, a district office obtains preliminary information to determine a community’s eligibility for assistance and the proposed project’s feasibility. If the community meets these requirements and funds are available, the district office asks the community to prepare a full application package. The district office provides the state office with data on the project, including the application package and the district office’s recommendation for approval. Most state offices have approval authority for loans of up to about $3 million; they can approve grants of any dollar amount. Under certain conditions, state offices must obtain final approval through USDA headquarters. Generally, USDA finances water and sewer projects through a combination of loans and grants. In addition, other funds—such as those from federal or state agencies or the applicant community—may be combined with financing from USDA. USDA state and district offices determine the applicant’s eligibility and the project’s feasibility, including the reasonableness of user charges, which USDA headquarters officials interpret as an affordable charge. USDA state and district offices determine the community’s ability to repay a loan, including consideration of the community’s outstanding debt to USDA. These offices initially attempt to finance the project through a loan. Since USDA expects its loans to be fully repaid, district and state offices estimate what the average monthly user charges for the water and/or sewer services would have to be in order to sufficiently cover anticipated costs and avoid defaulting on the loan. Typically, a community repays its loan through monthly charges collected from the residents who use these services. If USDA state and district offices conclude that the loan amount would result in an onerous user charge, they consider replacing a portion of the loan with a grant to bring the user charge down to a more manageable level. In addition, officials in some states encourage the local community to obtain funding from other sources, such as state and/or other federal agencies, to reduce the amount of the USDA loan and grant funds needed. The grant amount that USDA state and district offices provide for a specific project can vary for several reasons—for example, the amount of grant funds on hand, the urgency for the project, and competing demands for grant funds within the district and across the state. There are two principal limits on the grant provided for a particular project. First, legislation limits the amount of the grant to 75 percent of the project development costs and provides for higher grants for projects in communities that have lower population and income levels. By regulation, USDA limits some communities having a somewhat higher median household income to a maximum grant of 55 percent of the project development costs. Second, under USDA regulations, grants cannot be so large that they cause average monthly user charges to be lower than those prevailing in the area. A state office may also fund a project at less than the allowable amount if its grant allocations are not sufficient to provide maximum grant funds for that project. To determine the yearly user charge for a project, USDA state and district offices consider costs in four categories: debt service, operations and maintenance, reserve fund, and other costs. These offices add the yearly debt service calculation—including outstanding USDA debt—to the yearly costs for operations and maintenance to arrive at the total yearly cost. When applicable, these offices also add the cost of maintaining a reserve fund (generally 10 percent of debt service), which is used to replace certain types of equipment that have a relatively short useful life. This reserve fund should not be large enough to build a substantial surplus. Ordinarily, the total reserve will be equal to one average annual loan installment, accumulating at a rate of one-tenth of the total each year. In addition, USDA state and district offices may consider other costs, such as funded depreciation and delinquent accounts. To arrive at the total grant amount, these offices determine how much debt service a community can afford. They then factor in amortization over a period of time, usually 40 years. In deciding on the mix of loan and grant funds to award for water and sewer projects, USDA state and district officials estimate the maximum size of the grant on the basis of a comparison of a community’s median household income with the state’s poverty level. A community may not receive the maximum grant if further calculations of the debt service amount that the community can afford reveal that the grant should be less. A key factor in estimating affordability is determining how much the average customer can pay for water and/or sewer service on the basis of a community’s median household income. USDA officials may override this affordability measure and increase or decrease the grant amount to bring the user charge in line with the average charges paid by comparable communities for similar systems. However, officials may not change the grant amount if the change will result in user charges that are lower than those charged to customers in nearby communities. Representative William F. Clinger, Jr., asked us to review certain aspects of USDA’s Water and Waste Disposal Program. This report provides information on (1) funding levels for the program and the projects supported, (2) the formula that USDA uses to allocate loan and grant funds among its state offices, and (3) the approach that USDA state and district offices use to distribute funds within states. To address the first objective, we obtained access to the USDA database that contains information on the water and sewer program since its inception in the 1930s. We analyzed data for projects begun from fiscal year 1965 through June 1995—the period during which USDA was authorized to provide both grants and loans for water and sewer projects. We excluded (1) about 4,000 projects (with a value of about $1.3 billion in nominal dollars) from our analysis because USDA’s database did not provide the year in which the projects were begun and (2) about 3,000 additional projects because the database did not provide the dollar amounts for these loans and/or grants. We summarized, by state, information on USDA’s loans and grants and on other sources of funding. We converted amounts in the database to constant fiscal year 1994 dollars. We did not perform a reliability assessment of USDA’s database. To respond to the second objective, we reviewed the literature on allocation formulas used for distributing federal funds and spoke with experts in other federal and private agencies. We identified generally accepted criteria for the factors that should go into an allocation formula and compared these factors with those used for the current water and sewer allocation formula. We also analyzed allocation formulas used to distribute funding for other federal programs. To address the third objective, we reviewed files at USDA headquarters for a random sample of 120 projects receiving funding from fiscal year 1992 through fiscal year 1994. We selected 30 cases each from four of the five states that are the largest recipients of loan and grant funds (Mississippi, North Carolina, Ohio, and Pennsylvania). We analyzed the approach used to distribute funds within the states and identified variations in funding decisions. We visited these four states and talked with USDA water and sewer officials at the state level and with officials in 12 of USDA’s districts. We also talked with nine borrowers who had received grants or loans from USDA for water or sewer projects in two of these states. We performed our work from September 1994 through August 1995 in accordance with generally accepted government auditing standards. We provided copies of a draft of this report to USDA’s Rural Utilities Service for its comments. We met with several agency officials, including the Deputy Administrator of the Rural Utilities Service and the Director of the Water and Waste Disposal Division. These officials agreed that the information presented in the report is accurate. They provided new or clarifying information that we incorporated as appropriate. From fiscal year 1965 through June 1995, USDA supported the development of water and sewer projects in thousands of rural communities. The expenditures, number of projects, and average costs varied by state. On average, the water and sewer program provided about 70 percent of the funds for the projects that it supported. The remainder of the funds came from other sources such as the Environmental Protection Agency (EPA), states, and counties. Since fiscal year 1965, USDA has provided financial assistance to over 12,500 rural communities and almost 17,000 water and sewer projects. The number of projects supported and the amount of loan and grant funds provided varied, ranging from a low of two projects and about $5.6 million in the Western Pacific Territories to a high of more than 1,100 projects and $1.8 billion in expenditures in Texas. Furthermore, the average expenditure per project varied widely among the states. Table 2.1 shows the top five states in total expenditures and the average expenditure for each project in those states since fiscal year 1965. As table 2.1 shows, while total expenditures were comparable for three of the five states, the average expenditure per project and the average annual number of projects varied considerably. For example, the average expenditure per project in Ohio was about 2-1/2 times the expenditure in Mississippi. This occurs in part because the USDA office in Mississippi funded more water projects than did the USDA office in Ohio, which funded more sewer projects. In general, water projects are less costly than sewer projects. (App. I provides information on projects and expenditures by state.) Many projects that the water and sewer program supported also received funding from sources other than USDA, including the community itself, the state and county, and other federal sources, such as EPA. Figure 2.1 shows the amount and percentage of support provided by these sources and USDA. EPA ($6.3) USDA ($27.7) The $27.7 billion provided by USDA’s water and sewer program represents about 70 percent of the total expenditures on these projects from fiscal year 1965 through June 1995. The extent of all other funding sources varied widely by state—from 8 percent in New Jersey to 62 percent in Vermont. According to USDA officials in one of the four states we visited, they encouraged and aided applicants for the projects in soliciting funds outside of the USDA program. Projects in that state and in two others that we visited averaged over 30 percent in all other sources of funding. Conversely, the fourth state we visited relied more heavily on USDA’s water and sewer funds, obtaining only 15 percent of funding from all other sources. (See app. I for sources of funding by state.) The current water and sewer formula—which is based on rural population, poverty, and unemployment—is easy to administer and draws on data that are readily available and directed toward rural areas. As we have reported on a number of previous occasions, experts in public finance have identified three criteria—need, ability to pay, and differences in cost—that are commonly considered in allocation formulas aimed at producing an equitable distribution of funds among states. USDA’s current formula may partially satisfy the first two criteria but does not address the third. Data on need, on the ability to pay, and on certain cost differences are available from the Bureau of the Census, EPA, the Department of the Treasury, and the Bureau of Labor Statistics. USDA’s water and sewer formula is easy to administer because of its simplicity and its use of factors that are based on readily available data. It consists of three weighted factors for each state: rural population (50 percent), rural poverty (25 percent), and rural unemployment (25 percent). Rural population is measured by a state’s rural share of population as a percentage of the national rural population. Rural poverty is measured by the state’s rural population below the poverty level as a percentage of the national rural population below the poverty level. Rural unemployment is measured by the state’s nonmetropolitan unemployed population as a percentage of the national nonmetropolitan unemployed population. USDA officials informed us that they use rural population, poverty, and unemployment in the allocation formula because the data are readily available from the Bureau of the Census and Bureau of Labor Statistics and do not require any further alterations. (For population and poverty levels, data are collected every 10 years; for unemployment rates, data are collected annually.) In addition, the data are directed toward rural areas. Public finance experts have identified three criteria that are commonly considered in allocation formulas aimed at producing an equitable distribution of funds among states. These criteria are the (1) need for services or projects, (2) ability of states to fund projects from their own resources, and (3) differences between the states in the cost of providing these services. Some federal allocation formulas consider one or more of these criteria in distributing program funding to the states, as discussed below. The Advisory Commission on Intergovernmental Relations, reported that the “need for services” is the most common criterion used to allocate federal funds. Some formulas use direct indicators of this need. For example, the formula for the Highway Bridge Replacement and Rehabilitation Program is based on the number of a state’s bridges that are eligible for replacement or rehabilitation. Similarly, the formula for the Hazardous Waste Management State Program is based in part on a direct indicator of need—the number of hazardous waste management facilities in the state. This program assists states in transporting, treating, storing, and disposing of hazardous wastes. Indirect indicators of need, or proxies, may be used when direct factors are not available. For example, the Highway Planning and Construction, Interstate 4R Program formula contains a factor for vehicle miles traveled on interstate routes in a calendar year. This factor serves as a proxy for those interstate highways that are in the greatest need of repair. Indirect indicators of need often have the advantage of objectivity and prevent any perverse incentive effects that may result from the formula itself. However, when direct indicators of need are available, their use may more precisely target funds. A state’s ability to raise revenues from its own resources—its fiscal capacity—is also an important factor found in many federal allocation formulas. The rationale for including an ability-to-pay factor is that a greater share of funds should go to recipients who are least able to finance their needs from their own resources. Many federal and state grant programs over the past decade have included a measure of ability to pay in their formulas. Because it is readily available information, per capita income is the factor used almost exclusively to account for ability to pay. However, according to economists and other analysts, per capita income is not a comprehensive measure of ability to pay because it does not include other sources of income, such as corporate income and taxes paid by nonresidents (e.g., hotel and sales taxes). Therefore, using an indicator such as per capita income may understate states’ ability to pay. Several other factors could be used to develop a more comprehensive indicator of ability to pay, such as total taxable resources. This indicator, developed by the Department of the Treasury, is an average of per capita income and per capita gross state product. By averaging gross state product with personal income, total taxable resources covers more types of income than does personal income alone, including income received by nonresidents. This measure is used in the formula specified in the 1987 reauthorization of the block grant for the Alcohol, Drug Abuse, and Mental Health Program. Many allocation formulas include an adjustment for cost disparities across states. Ideally, for these formulas to reflect cost differences fairly, they must incorporate factors that reflect differences between states in costs that are beyond the states’ direct control. One formula that includes an indicator to adjust for costs is the formula for the Highway Bridge Replacement and Rehabilitation Program. This formula considers the costs of replacing or improving bridges in different states. The current formula may partially reflect the need for services and the ability to pay for such services, but it does not reflect cost differences between the states. First, to the extent that a state’s relative need for services is proportional to rural population and poverty, the population and poverty factors may serve as a proxy for need. But the formula’s reliance on poverty data can result in more funding to a state that has more resources to help itself than its poverty data would indicate. Such a state may have both a relatively high average income and a high level of poverty. Also, poverty data are not adjusted for cost-of-living differences across states. Second, the formula partially provides a means for measuring a state’s ability to pay for needed water or sewer services. The current formula’s unemployment factor provides an indirect measure of a state’s financial capacity but does not directly address a state’s ability to pay for services. In addition, the use of the unemployment rate as a targeting mechanism cannot be expected to reflect the economic conditions of rural areas. According to USDA, rural workers are more likely to rely on two or more part-time jobs rather than one full-time job. These part-time jobs do not show up in unemployment statistics. Also, the unemployment rate may not be representative of the economic condition of self-employed farmers, whose employment status is unlikely to change in good or bad times. On the other hand, the current formula does not adjust for cost differences. It does not recognize that the costs for building and maintaining water and sewer projects differ from one state to another. These costs can differ because of state-to-state differences in labor costs or other inputs as well as the amount of resources needed to accomplish the project. For example, costs may be higher because of a harsh winter climate or the topography of certain states, making it necessary to bury water or sewer pipes more deeply or to drill through rocky terrain. Most data that could be incorporated into a formula that addresses a community’s need, ability to pay, and cost differences are currently available. Appendix II provides details on the availability of such data. Any changes that would incorporate such data, however, could alter the amounts of loan and grant funds that states receive. Depending on the factors selected and their respective assigned weights, changes could be significant. The ultimate results of any changes would depend upon assumptions about the relative importance of factors. We did not analyze how potential changes would affect individual states. USDA state and district officials have the authority to vary the amount of grant and loan funds that they award to communities eligible to receive funding for water and sewer projects. The officials may base their decisions on either the applicant communities’ median household income (MHI) or the user rates for similar systems. This flexibility in funding decisions has the advantage of allowing state and district offices to vary the mix of grant and loan funds among competing projects. This same flexibility results in different funding decisions for similar communities. USDA state and district officials decide on whether to provide only a loan or a mix of loan and grant funds for water and sewer projects by determining what constitutes an affordable payment or average user charge. As discussed in chapter 1, if a loan by itself would result in a user charge that is too high, officials can reduce the loan’s amount by providing grant funds. The amount of the grant is ultimately determined by considering a community’s MHI or the results of a comparison between the proposed system and other similar systems. USDA officials advised us that most funding decisions are based on user charges for similar systems in the area, rather than on the community’s MHI. According to a number of USDA state and district officials with whom we spoke, the option of comparing similar communities and systems provides them with latitude in distributing funds within the state. This option allows them to provide more or less funds to projects, depending on the number and cost of projects competing for funds. Accordingly, these states could either fund multiple projects at reduced grant levels or fewer projects at higher levels. USDA offices in all four states chose the latter—assisting a larger number of projects with relatively lower amounts of grants. For example, USDA officials in one state told us that they had a 4- to 5-year backlog of projects totaling about $220 million. In this state, when choosing similar systems for comparison, officials were more likely to pick systems with higher user charges, thus establishing a lower grant amount for the project under consideration and spreading grant funds among competing projects. According to USDA headquarters, state, and district officials, selecting comparable communities and user charges is inherently judgmental. Water and sewer systems and user charges can differ because of such factors as the type and age of the system and the size and density of the population served. While the flexibility for selecting similar systems provides latitude in determining the amount of a grant that a particular project will receive, it also means that differing funding decisions may be made for similar communities. We identified variations in funding decisions both between and within the four states we visited. Table 4.1 provides information on four communities—one from each of the four states we visited. The district and state offices in each of the states based their funding decisions for these communities on the user charges for similar water and/or sewer systems in comparable communities within their respective states. The table presents project development costs, the community’s MHI, the community’s maximum grant eligibility, the grant’s amount based on MHI, the amount of the grant awarded, the annual user charges, and the community’s user charges used for comparison. The community in State 1 was eligible for a grant of up to 55 percent of its project development costs, on the basis of its median household income when compared with the state’s median household income. As table 4.1 shows, USDA provided this community with the maximum grant, about $3.4 million. USDA arrived at an annual user charge of $147, which was comparable with the annual charges of three other communities. In contrast, the community in State 2 was eligible for a 75-percent grant but received no grant funds even though it had a median household income similar to that of the first community. Without a grant, the community in State 2 projected a user charge of $376 annually, which was 2-1/2 times higher than the user charge for the first community. However, this user charge was comparable with the three communities that the district office had selected for comparison in that state. USDA made differing funding decisions for these two communities. While the community in State 2 was eligible for a larger grant than the community in State 1, it received no grant at all. Similarly, the communities in the other two states were each eligible for a grant of 75 percent, but the grant amounts differed. One community’s annual user charge of $182 was close to an average of the three communities selected for comparison, while the other community received a grant amount that resulted in an annual user charge lower than that of any of the three systems identified as similar. We also found variations in the approaches used within individual states to determine how much grant funding, if any, USDA would provide to a particular community. Table 4.2 presents information similar to that in table 4.1 for four communities within the same state. For these communities, USDA based its decisions on user charges in similar communities. On the basis of its MHI, Community A was eligible for a grant of up to 55 percent of its project development costs and received a grant of $572,000. In contrast, Community B was eligible for a 75-percent grant but received no grant funds. For Community A, the annual user charge was $396, which was higher than the annual user charges for the three communities used for comparison. For Community B, the annual user charge was $376, which was higher than two of the communities used for comparison. USDA made differing funding decisions for Communities A and B. Community A, which had a higher MHI than Community B, received a grant, while Community B received no grant. Our analysis also showed that Communities B, C, and D were eligible for grants up to 75 percent ($5.5 million, $2.4 million, and $657,000, respectively). While USDA compared similar communities to arrive at projected user charges for these three applicants, it provided no grant to Community B, almost the maximum grant to Community C ($2.3 million), and less than half the maximum grant to Community D ($300,000). Several USDA district officials in this state told us that they regularly choose systems for comparison that support a $30 to $35 monthly charge because they believe that user charges in this range are necessary to get the state office’s approval for the project. However, USDA state officials disagreed with the district officials’ views that a $30 to $35 monthly charge was expected. Nonetheless, in another state, USDA state and district officials told us that they emphasize having a consistent outcome for user charges in their state. They informed us that they expected the awards to projects to result in monthly user charges of about $30 for water projects and about $35 for sewer projects. Also, within each of the four states visited, USDA’s rationale for making grant determination decisions was often not documented in the files. For example, files on the projects frequently showed that the similar systems approach was used but the communities and user charges selected for comparison were not identified.

Summary: Pursuant to a congressional request, GAO reviewed the Department of Agriculture's (USDA) process for allocating and distributing loan and grant funds for water and sewer projects, focusing on: (1) funding levels for the Water and Waste Disposal Program; (2) the formula used to allocate funds among USDA state offices; and (3) the approach that USDA state offices use to distribute funds within states. GAO held that: (1) the USDA water and sewer program has provided loan and grant support totalling about $28 billion, supporting almost 17,000 projects, and assisting over 12,500 communities throughout the United States; (2) the three factors that USDA considers in its allocation formula for water and sewer funds are rural population, rural poverty, and rural unemployment; (3) no state may receive more than 5 percent of the total available funds in the initial allocation; (4) the allocation formula may partially reflect states' needs and ability to pay, but it does not reflect cost differences between states; and (5) although USDA state and district offices have considerable flexibility in determining the amount of grant assistance for individual projects under the current approach, this flexibility can result in differing funding decisions for similar communities.