Under the Housing Act of 1937, as amended, the Congress created the federal public housing program to assist communities in providing decent, safe, and sanitary dwellings for low-income families. However, it was not until 1975 that HUD established a permanent system known as the Performance Funding System (PFS) for subsidizing public housing. For years, the public housing program was self-sufficient because it was open only to residents whose incomes were high enough for them to be able to pay rents that would cover operating costs. The program began to move toward serving poorer households with the Housing Act of 1949, which required incomes of eligible households to be 20 percent below the income necessary to rent decent private housing. Also, during the 1950s and 1960s, the average income of public housing tenants began to fall as the more upwardly mobile households found affordable housing elsewhere. By 1969, public housing had shifted to serving the poorest households, those who had difficulty paying rents that were high enough to cover the full costs of public housing operations. As a result, the Congress passed the Brooke Amendments, beginning in 1969, which limited the rent that tenants could be charged to 25 percent of their incomes and authorized a program of federal subsidies to pay for the operating costs that public housing agencies could no longer meet with rental income alone. By the mid-1970s, rising subsidy costs, along with concern in the Office of Management and Budget and the Congress that the system did not provide an incentive for good management, led to the 1974 Housing Act mandating that the Secretary of HUD establish a mechanism for subsidizing the cost of providing public housing. As a result, HUD developed PFS in 1975; since then, PFS has come under almost constant review in efforts by HUD and others to find a more effective mechanism for allocating congressional appropriations to housing agencies. Provisions in pending housing reform legislation would require HUD to create a block grant to cover operating expenses and to develop a new formula for allocating that grant. After implementing PFS in 1975, HUD began allotting operating subsidies to housing agencies on the basis of their costs in the base year 1975. Since then, HUD has adjusted the base year costs annually for inflation and other factors to update the allowable costs of operating public housing. The subsidy that HUD provides is the difference between a housing agency’s income and these allowable costs. Although HUD did not base housing agencies’ allowable expenses on what it should cost to provide a standard set of housing services, twice over the program’s life the Department has used quantitative cost models, based on two different sets of cost data, to better define subsidy levels: once at the outset to establish an upper limit for allowable costs and again in 1992 to adjust some agencies’ costs that, according to the second cost model, were less than 85 percent of their predicted levels. HUD and its contractors did not believe that the results of the statistical analysis provided a standard of what agency expenses should be or need to be to efficiently provide a commonly understood standard of service in public housing. HUD implemented its system for subsidizing public housing agencies in 1975, basing it on the HUD-approved operating expense level incurred by housing agencies that year. HUD also developed a cost model, called the “prototype equation,” that was based on the costs of a group of well-managed agencies. The equation was used to predict housing agencies’ operating costs and to thereby establish a limited range of costs within which HUD expected housing agencies to operate. HUD and the Urban Institute, which developed the model for HUD, reported that the model did not produce an estimate of what housing agencies should or need to spend for housing services. Instead, based on a set of five cost-related factors, the model produced for every agency a predicted, or prototype, expense level that could then be compared with the actual expenditures that formed the subsidy’s basis. HUD believed that this comparison showed which agencies had spending that significantly exceeded the comparable expenses derived from a group of well-managed agencies, after controlling for their differences in the five factors. Without a method to establish what operating expenses are necessary to provide some standard level of services—nor a method to define what that standard level of services would consist of—HUD chose to use each agency’s actual operating expenses in 1975 as its standard baseline amount, not including utility and audit expenses. Since then, the subsidy a housing agency receives each year is its prior year’s allowable expenses—adjusted for (1) additions or deletions to its housing stock, (2) inflation, and (3) an additional 0.5 percent to allow for higher costs associated with an aging housing stock—less the amount of rental and other income the housing agency receives. Thus, the PFS subsidy is the shortfall between an agency’s allowable expenses and its income. In years when the congressional appropriation has not been sufficient to cover the shortfall, HUD has proportionally reduced each agency’s subsidy to conform to the amount appropriated. To develop the prototype equation, a 1975 study by the Urban Institute identified certain operating characteristics of housing agencies that were related to the agencies’ operating expenditures. On the basis of operating performance and responses to questionnaires, the study identified a group of local agencies considered to be well managed at the time. The Urban Institute used these agencies’ costs to identify five characteristics of a local agency’s housing operations that were directly related to operating expenditures per housing unit, per month, called per unit-month costs, and determined the relative impact of the characteristics on the overall cost of operations. On the basis of the Urban Institute’s study, HUD established an upper limit for expenses and beginning in 1975 limited the growth in allowable expenses for housing agencies that had expenses that significantly exceeded the level predicted for them by the prototype equation. In 1992, HUD implemented the results of a second study in a subsidy review process mandated by the 1987 Housing and Community Development Act. This study’s approach was similar to the Urban Institute’s approach. It also identified five cost factors that were related to local agencies’ operating costs, but it used different factors and drew on the past expense levels of a much larger sample of housing agencies. The act required this study, in part, to correct inequities in the base year expense level, to accurately reflect changes in operating circumstances, and to reflect the higher cost of operating in an economically distressed unit of local government. If an agency’s allowable expense level was less than 85 percent of the amount calculated by the new PFS formula developed in the 1992 study, the allowable expense level would be increased to the 85-percent level. At that time, this adjustment was expected to effect 868 housing agencies, most of which were small. HUD believed that its PFS formula was not sufficiently accurate to change agencies’ allowable costs that differed by less than 15 percent from the value predicted by the formula. A lower percentage would have been more costly because it would have permitted more housing agencies to increase their allowable costs. Because the agencies that qualified for the increase in allowable expenses were comparatively small, this review added only 1.4 percent to the total federal subsidy for that year. Although HUD’s 1992 study related operating costs to certain characteristics of a housing agency, HUD did not use the new formula to establish specific allowable expense levels for all housing agencies. Instead, for most agencies, the allowable expense level continued to be based on past actual costs. HUD officials believed that the 1992 cost model improved on the prototype equation in several respects, but they still had concerns about whether the model reflected all the important circumstances and conditions affecting housing agencies’ costs. For example, none of the cost factors accounted for the condition and quality of the housing stock. In addition, neither the Urban Institute’s nor HUD’s analysis controlled for differences in the effect that varying maintenance practices would have had on expenditures and on the varying physical condition of agencies’ housing stock. Consequently, the studies’ statistical analyses simply reflect historical spending patterns rather than differences in the cost conditions at different locations. Moreover, the spending patterns analyzed in 1992 might not have accurately reflected the true costs of operating public housing because spending had been limited since 1975 by housing agencies’ available revenue—the sum of the PFS subsidy and rental and other income. The operating subsidies that HUD provides through PFS are not sufficient to adequately supplement some housing agencies’ operations budgets. Although these agencies’ base year costs were limited by the prototype formula where necessary, adjusted for inflation and other effects, and converted into their current allowable expense levels, the expense levels still reflect housing conditions, management policies, and, most importantly, the spending patterns that existed almost a quarter of a century ago. PFS has not adapted to the housing agencies’ changing needs, residents, or operating circumstances. Therefore, the housing agencies that either had inadequate resources in 1975 because they were serving extremely poor residents or had changes in their operating circumstances over the years that had a substantial impact on their costs may not be receiving adequate subsidies today to operate effectively. For example, each of the four large housing agencies we visited had experienced changes in its circumstances since PFS was implemented in 1975. The significant actions taken by the housing agencies’ managers to address these changes demonstrate that the operating subsidies they receive from HUD may not be sufficient to meet their agencies’ needs. These agencies have deferred maintenance expenses, reduced staffing in critical areas, and supplemented their operating budgets with funding from other federal grants. The four agencies took these and other actions, despite being reasonably well managed according to HUD’s management assessment program. Finally, we found that 17 percent of the housing agencies had had declining operating reserves during their fiscal years ending in 1992 through 1996. In particular, 4 of the 21 extra large housing agencies (those operating 6,600 or more housing units) had declining reserve levels in 3 of the last 4 years.