In 1986, the United States entered into its original Compact of Free Association with the FSM. The compact comprised a framework for the United States to work toward achieving three main goals: (1) to secure self-government for the FSM, (2) to ensure certain national security rights for all parties, and (3) to assist the FSM in its efforts to advance economic development and self-sufficiency. Under the original compact, the FSM also benefited from numerous U.S. federal programs, and their citizens were allowed to live and work in the United States as nonimmigrants and to stay for long periods of time. Although the original compact’s first and second goals were met, the FSM did not achieve economic self-sufficiency. The FSM gained independence in 1978, and key defense rights were established. However, the compact’s third goal was to be accomplished primarily through U.S. direct financial assistance totaling about $1.5 billion from 1987 through 2003. Although U.S. financial assistance maintained higher income levels than the FSM could have achieved without support, FSM estimated per capita GDP at the compact’s close did not differ substantially, in real terms, from its per capita GDP in the early 1990s. In addition, we found that the U.S. and FSM governments provided little accountability over compact expenditures and that many compact-funded projects encountered problems related to poor planning and management, inadequate construction and maintenance, or misuse of funds. In 2003, the United States approved an amended compact with the FSM that (1) continues the defense relationship; (2) strengthens immigration provisions; and (3) provides an estimated $2.3 billion to the FSM for 2004 through 2023 (see attachment II). The amended compact, which took effect in June 2004, identifies the additional 20 years of grant assistance as intended to assist the FSM in its efforts to promote the economic advancement and budgetary self-reliance of its people. Financial assistance is provided in the form of annual sector grants and contributions to the trust fund. The amended compact and its subsidiary agreements, along with the FSM’s development plan, 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. To provide increasing U.S. contributions to the FSM’s trust fund, 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 attachment III). For example, in 2004 U.S. dollar terms, FSM per capita grant assistance will likely fall from around $1,352 in 1987 to around $562 in 2023. Under the amended compact, annual grant assistance is to be provided according to an implementation framework with several components (see attachment IV). For example, prior to the annual awarding of compact funds, the FSM must submit a development plan that identifies goals and performance objectives for each sector. The FSM government is also required to monitor day-to-day operations of sector grants and activities, submit periodic financial statements 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 JEMCO are to approve annual sector grants and evaluate the countries’ management of the grants and their progress toward program and economic goals. The amended compact and subsidiary trust fund agreement also provide for the formation of an FSM trust fund committee to, among its other duties, hire a money manager, oversee the fund’s operation and investment, and provide annual reports on the fund’s profitability. The FSM economy shows limited potential for developing sustainable income sources other than foreign assistance to offset the annual decline in U.S. compact grant assistance. Moreover, the FSM has not enacted economic policy reforms needed to improve its growth prospects. The FSM’s economy shows continued dependence on government spending of foreign assistance and limited potential for expanded private sector and remittance income. Total government expenditures in 2006, over half of which were funded by external grants, accounted for about 65 percent of GDP. The FSM’s government budget is characterized by limited tax revenue paired with growing government payrolls. For example, FSM taxes have consistently provided less than 25 percent of total government revenue; however, payroll expenditures have increased as a percentage of total government spending, from 38 percent in 2000 to 45 percent in 2006. The FSM development plan identifies fishing and tourism as key potential private sector growth industries. However, the two industries together provide only about 6 percent of employment. Further, according to economic experts, growth in these industries is limited by factors such as the FSM’s geographic isolation, lack of tourism infrastructure, inadequate interisland shipping, limited pool of skilled labor, and growing danger of overfishing. Although remittances from emigrants could provide increasing monetary support to the FSM, evidence suggests that FSM emigrants are currently limited in their income-earning opportunities abroad, owing to inadequate education and vocational skills. Although the FSM has undertaken some efforts aimed at economic policy reform, it has made limited progress in implementing key tax, public sector, land, and foreign investment reforms that are needed to improve its growth prospects. For example: Tax reform. After several years of national policy dialogue to address a tax system that economic experts describe as inequitable and inefficient, the FSM established a tax reform executive steering committee in December 2005. The committee endorsed key elements of tax reform recommended by experts and the FSM’s Tax Reform Task Force, such as a value-added tax (VAT), a net profit tax, and a unified tax authority. In April 2007, the committee endorsed a 3-year implementation plan. However, as of April 2008, legislation required for implementing these measures had not yet been passed. Public sector reform. Although the FSM has endorsed public sector reform aimed at reducing wage and subsidy expenditures, limited progress has been made in addressing annual fiscal deficits, which amounted to about 5 percent of GDP in 2005 and 2006. Slow progress in implementing public sector reforms, combined with a lower level of grant assistance, precipitated fiscal crises in Kosrae and Chuuk. Fiscal adjustment programs were subsequently created for the two states based on, among other things, reductions-in-force wage savings and increased state tax rates. Kosrae completed its adjustment program in 2007, but Chuuk’s implementation of its program began only recently. Moreover, all FSM governments continue to conduct a wide array of commercial enterprises that require subsidies. Land reform. In attempts to modernize a complex land tenure system, the FSM has established land registration offices. However, these offices have lacked a systematic method for registering parcels, instead waiting for landowners to voluntarily initiate the process. Continued uncertainties over land ownership and land values create costly disputes, disincentives for investment, and problems regarding the use of land as an asset. Foreign investment reform. Economic experts and private sector representatives describe the overall climate for foreign investment in the FSM 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. Some FSM states also require a certain percentage of local ownership in foreign investment. Although the FSM development plan includes objectives for economic reform, JEMCO did not begin to address the country’s slow progress in implementing these reforms until August 2006, 2 years into the amended compact. Further, while JEMCO recently approved some funding to support FSM efforts at public sector reform, key challenges to improving private sector growth remain. Although the FSM has allocated compact grants to the sectors targeted by the compact, immediate problems in some sectors persist, and several factors have hindered the FSM’s use of the funds to meet long-term development goals. In addition, administrative deficiencies have limited the FSM’s ability to account for its use of the grants for these long-term goals. Further, although OIA has monitored early compact activities, program implementation challenges have hampered its oversight. In 2004 through 2008, the FSM targeted compact grants largely according to compact priorities, allocating 35 percent of the funds for education, 27 percent for infrastructure, and 22 percent for health (see attachment V). However, the FSM has completed only three infrastructure projects, and more than $67 million of the $82.5 million (approximately 82 percent) allocated for infrastructure grants in 2004 through 2007 remains unspent. Lack of progress in this sector is owed to national and state disagreements over infrastructure priorities, problems associated with the project management unit, and Chuuk’s inability to secure land leases. Unspent funds for other sector grants from 2004 to 2007 amounts to an additional $14.9 million, or around 7 percent of funds allocated (see attachment VI). Additionally, numerous factors have limited the government’s use of compact funds to meet long-term development needs. For example: Lack of government consensus. Interior and State 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 FSM central government, which is represented on JEMCO, does not control the majority of compact funds and has been unable to secure agreement from the state governments regarding the use of compact funds. Lack of needs analysis. The allocation of FSM grants among its four states is not needs based and has resulted in significant differences in per capita funding, creating varying levels of government services across the states. For example, in 2006, Yap state received approximately $1,963 in education funding per student, while Chuuk state received $626 per student. More recently, in 2007, the national government’s share of grant funding increased from 8.65 percent to 10 percent and the allocation of compact funds to the four states decreased.