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. 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. 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. 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. 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. 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. 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. 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. 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. 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). 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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). The following are GAO’s comments on the Department of the Interior letter dated May 16, 2006. 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. The following is GAO’s comment on the Department of Health and Human Services letter dated May 23, 2006. 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. The following is GAO’s comment on the Federated States of Micronesia letter dated May 30, 2006. 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. The following are GAO’s comments on the Republic of the Marshall Islands letter dated June 1, 2006. 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. 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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Summary: 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. 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.