In 1986, the United States, the FSM, and the RMI entered into the original Compact of Free Association. 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. Under the original compact, the FSM and RMI also benefited from numerous U.S. federal programs, while citizens of both nations exercised their right under the compact to live and work in the United States as “nonimmigrants” and to stay for long periods of time. Although the first and second goals of the original compact were met, economic self-sufficiency was not achieved under the first compact. The FSM and the RMI became independent nations in 1978 and 1979, respectively, and the three countries established key defense rights, including securing 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 that totaled $2.1 billion from 1987 through 2003. However, estimated FSM and RMI per capita GDP levels at the close of the compact did not exceed, in real terms, those in the early 1990s, although U.S. assistance had maintained income levels that were higher than the two countries could have achieved without support. In addition, we found that the U.S., FSM, and RMI governments provided little accountability over compact expenditures and that many compact-funded projects experienced problems because of poor planning and management, inadequate construction and maintenance, or misuse of funds. In 2003, the United States approved separate amended compacts with the FSM and RMI that (1) continue the defense relationship, including a new agreement providing U.S. military access to Kwajalein Atoll in the RMI through 2086; (2) strengthen immigration provisions; and (3) provide an estimated $3.6 billion in financial assistance to both nations from 2004 through 2023, including about $1.5 billion to the RMI (see app. I). The amended compacts identify the additional 20 years of grant assistance as intended to assist the FSM and RMI governments in their efforts to promote the economic advancement and budgetary self-reliance of their people. Financial assistance is provided in the form of annual sector grants and contributions to each nation’s trust fund. The amended compacts and their subsidiary agreements, along with the countries’ development plans, target the 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. Further, the amended compact stipulates that certain funding be made available to address the population’s needs on Kwajalein Atoll. To provide increasing U.S. contributions to the FSM’s and the RMI’s trust funds, grant funding decreases annually and will likely result in falling per capita grant assistance over the funding period and relative to the original compact (see fig. 1). For example, in 2004 U.S. dollar terms, FSM per capita grant assistance will fall from around $1,352 in 1987 to around $562 in 2023, and RMI per capita assistance will fall from around $1,170 in 1987 to around $317 in 2023. Under the amended compacts, annual grant assistance is to be made available in accordance with an implementation framework that has several components (see app. II). For example, prior to the annual awarding of compact funds, the countries must submit development plans that identify goals and performance objectives for each sector. The FSM and RMI governments are also required to monitor day-to-day operations of sector grants and activities, submit periodic financial and performance reports for the tracking of progress against goals and objectives, and ensure annual financial and compliance audits. In addition, the U.S. and FSM Joint Economic Management Committee (JEMCO) and the U.S. and RMI Joint Economic Management and Financial Accountability Committee (JEMFAC) are to approve annual sector grants and evaluate the countries’ management of the grants and their progress toward compact goals. The amended compacts also provide for the formation of FSM and RMI trust fund committees to, among other things, hire money managers, oversee the respective funds’ operation and investment, and provide annual reports on the effectiveness of the funds. The RMI economy shows limited potential for developing sustainable income sources other than foreign assistance to offset the annual decline in U.S. compact grant assistance. In addition, the RMI has not enacted economic policy reforms needed to improve its growth prospects. The RMI’s economy shows continued dependence on government spending of foreign assistance and limited potential for expanded private sector and remittance income. Since 2000, the estimated public sector share of GDP has grown, with public sector expenditure in 2005—about two-thirds of which is funded by external grants—accounting for about 60 percent of GDP. The RMI’s government budget is characterized by limited tax revenue paired with growing government payrolls. For example, RMI taxes have consistently provided less than 30 percent of total government revenue; however, payroll expenditures have roughly doubled, from around $17 million in 2000 to around $30 million in 2005. The RMI development plan identifies fishing and tourism as key potential private sector growth industries. However, the two industries combined currently provide less than 5 percent of employment, and both industries face significant constraints to growth that stem from structural barriers and a costly business environment. According to economic experts, growth in these industries is limited by factors such as geographic isolation, lack of tourism infrastructure, inadequate interisland shipping, a limited pool of skilled labor, and a growing threat of overfishing. Although remittances from emigrants could provide increasing monetary support to the RMI, evidence suggests that RMI emigrants are currently limited in their income-earning opportunities abroad owing to inadequate education and vocational skills. For example, the 2003 U.S. census of RMI migrants in Hawaii, Guam, and the Commonwealth of the Northern Marianas Islands reveals that only 7 percent of those 25 years and older had a college degree and almost half of RMI emigrants lived below the poverty line. Although the RMI has undertaken efforts aimed at economic policy reform, it has made limited progress in implementing key tax, land, foreign investment, and public sector reforms that are needed to improve its growth prospects. For example: 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 administrative capacity. Although the RMI has focused on improving tax administration and has raised some penalties and tax levels, legislation for income tax reform has failed and needed changes in government import tax exemptions have not been addressed. In attempts to modernize a complex land tenure system, the RMI has established land registration offices. However, such offices have lacked a systematic method for registering parcels, instead waiting for landowners to voluntarily initiate the process. For example, only five parcels of land in the RMI had been, or were currently being, registered as of June 2006. Continued uncertainties over land ownership and land values create costly disputes, disincentives for investment, and problems regarding the use of land as an asset. Economic experts and private sector representatives describe the overall climate for foreign investment in the RMI as complex and nontransparent. Despite attempts to streamline the process, foreign investment regulations remain relatively burdensome, with reported administrative delays and difficulties in obtaining permits for foreign workers. The RMI government has endorsed public sector reform; however, efforts to reduce public sector employment have generally failed, and the government continues to conduct a wide array of commercial enterprises that require subsidies and compete with private enterprises. As of June 2006, the RMI had not prepared a comprehensive policy for public sector enterprise reform. Although the RMI development plan includes objectives for economic reform, until August 2006—two years into the amended compact— JEMFAC did not address the country’s slow progress in implementing these reforms. The RMI has allocated funds to priority sectors, although several factors have hindered its use of the funds to meet long-term development needs. Further, despite actions taken to effectively implement compact grants, administrative challenges have limited its ability to ensure use of the grants for its long-term goals. In addition, although OIA has monitored early compact activities, it has also faced capacity constraints. The RMI allocated compact funds largely to priority sectors for 2004-2006. The RMI allocated about 33 percent, 40 percent, and 20 percent of funds to education, infrastructure, and health, respectively (see fig. 2). The education allocation included funding for nine new school construction projects, initiated in October 2003 through July 2006. However, various factors, such as land use issues and inadequate needs assessments, have limited the government’s use of compact funds to meet long-term development needs. For example: Management and land use issues in Ebeye. The RMI government and Kwajalein landowners have been disputing the management of public entities and government use of leased land on the atoll. Such tensions have negatively affected the construction of schools and other community development initiatives. For example, the government and landowners disagreed about the management of the entity designated to use the compact funds set aside for Ebeye special needs; consequently, about $3.3 million of the $5.8 million allocated for this purpose had not been released for the community’s benefit until after September 2006.