    Compact of Free Association: Palau's Use of and Accountability
    for U.S. Assistance and Prospects for Economic Self-Sufficiency
    (10-JUN-08, GAO-08-732).

    The Compact of Free Association between the Republic of Palau and
    the United States entered into force on October 1, 1994, with the
    U.S. interest of promoting Palau's self-sufficiency and economic
    advancement. The compact and its related subsidiary agreements
    provide for a 15-year term of economic assistance. In fiscal year
    2009, the two governments must review the terms of the compact
    and related agreements and agree on any modifications. The
    Department of the Interior (DOI) has primary responsibility for
    oversight of Palau's use of compact funds. GAO was requested to
    report on (1) the provision of compact and other U.S. assistance
    to Palau in fiscal years 1995-2009; (2) Palau's and U.S.
    agencies' efforts to provide accountability over Palau's use of
    federal funds in 1995-2006; and (3) Palau's prospects for
    achieving economic self-sufficiency. GAO reviewed Palau's compact
    annual reports, financial statements and internal control reports
    for fiscal years 1995-2006, as well as other compact-related
    documentation. GAO interviewed officials from the U.S. and Palau
    governments and conducted fieldwork in Palau.
    -------------------------Indexing Terms-------------------------
    REPORTNUM:   GAO-08-732
        ACCNO:   A82311
      TITLE:     Compact of Free Association: Palau's Use of and
    Accountability for U.S. Assistance and Prospects for Economic
    Self-Sufficiency
         DATE:   06/10/2008
      SUBJECT:   Accountability
    	     Cost analysis
    	     Economic analysis
    	     Economic development
    	     Economically depressed areas
    	     Federal aid programs
    	     Federal aid to foreign countries
    	     Financial disclosure
    	     Financial management
    	     Financial statement audits
    	     Fiscal policies
    	     Foreign aid programs
    	     Foreign economic assistance
    	     Foreign financial assistance
    	     Foreign governments
    	     Foreign policies
    	     Funds management
    	     Internal controls
    	     International agreements
    	     International economic relations
    	     International relations
    	     Private sector
    	     Reporting requirements
    	     Trust funds
    	     Cost estimates
    	     Compact of Free Association
    	     Palau

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    GAO-08-732

    This is the accessible text file for GAO report number GAO-08-732
    entitled 'Compact Of Free Association: Palau's Use of and
    Accountability for U.S. Assistance and Prospects for Economic Self-
    Sufficiency' which was released on June 10, 2008.

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    Report to Congressional Committees:

    United States Government Accountability Office:
    GAO:

    June 2008:

    Compact Of Free Association:

    Palau's Use of and Accountability for U.S. Assistance and Prospects for
    Economic Self-Sufficiency:

    GAO-08-732:

    GAO Highlights:

    Highlights of GAO-08-732, a report to congressional committees.

    Why GAO Did This Study:

    The Compact of Free Association between the Republic of Palau and the
    United States entered into force on October 1, 1994, with the U.S.
    interest of promoting Palau�s self-sufficiency and economic
    advancement. The compact and its related subsidiary agreements provide
    for a 15-year term of economic assistance. In fiscal year 2009, the two
    governments must review the terms of the compact and related agreements
    and agree on any modifications. The Department of the Interior (DOI)
    has primary responsibility for oversight of Palau�s use of compact
    funds. GAO was requested to report on (1) the provision of compact and
    other U.S. assistance to Palau in fiscal years 1995-2009; (2) Palau�s
    and U.S. agencies� efforts to provide accountability over Palau�s use
    of federal funds in 1995-2006; and (3) Palau�s prospects for achieving
    economic self-sufficiency. GAO reviewed Palau�s compact annual reports,
    financial statements and internal control reports for fiscal years 1995-
    2006, as well as other compact-related documentation. GAO interviewed
    officials from the U.S. and Palau governments and conducted fieldwork
    in Palau.

    What GAO Found:

    For fiscal years 1995-2009, U.S. aid to Palau is expected to exceed
    $852 million. Compact direct assistance will account for 48 percent of
    U.S. assistance; this assistance provides general budgetary support for
    Palau�s government operations, including initial investment in a trust
    fund intended to provide annual distributions of $5 million in 1999-
    2009 and $15 million in 2010-2044. Compact federal services such as
    postal, aviation, and weather services will account for about 3 percent
    of assistance, and construction of a road, finished in 2007, will
    account for 17 percent of assistance. Palau�s receipt of federal
    programs, providing services such as education grants and community
    health care, will account for approximately 31 percent of assistance.

    Single audit reports for fiscal years 1995-2006 show that Palau has
    made progress in its financial accountability through improvements in
    the timeliness and reliability of its financial statements. However,
    the reports show that Palau has persistent internal control weaknesses
    over financial reporting and over compliance with laws and regulations
    governing federal grants. According to Palau officials, inadequate
    capacity in financial accounting resources and expertise limits Palau�s
    ability to address these weaknesses in a timely way. These weaknesses
    put at risk Palau�s ability to sustain its progress in financial
    accountability and to operate a major federal program according to
    applicable requirements. Palau met most compact and subsidiary
    agreement accountability requirements. However, although DOI used
    single audit reports and Palau�s compact annual reports to monitor
    Palau�s use of compact funds, DOI�s oversight was lacking in some
    matters.

    Palau�s prospects for economic self-sufficiency depend on four key
    factors:

    * Levels of continued U.S. assistance. Given the $10 million scheduled
    increase in Palau�s annual trust fund withdrawals in fiscal year 2010,
    the expiration of $13.3 million in compact direct assistance will
    likely reduce Palau�s national government revenues by less than 4
    percent. However, future levels of discretionary federal
    programs�estimated at $11.9 million in 2009�could have a more
    significant fiscal impact. Also, unless compact federal services are
    extended, Palau will lose services funded by U.S. agencies estimated to
    cost almost $1.6 million in 2009.

    * Availability and value of trust fund distributions. Palau�s trust
    fund can distribute $15 million per year for 35 years if it earns a
    compounded annual return of at least 8.1 percent, a rate lower than the
    average earned thus far. However, market volatility could lead to the
    trust fund�s depletion after 2016. Moreover, inflation will cause the
    distributions to lose value over time.

    * Fiscal reform. To reduce its reliance on trust fund financing, Palau
    will require fiscal reforms to increase revenues and decrease
    expenditures.

    * Private sector growth. Palau will need to improve its business
    environment by addressing problems with its foreign investment climate;
    financial system; and land, labor, and commercial policies that
    currently discourage private sector growth.

    What GAO Recommends:

    GAO recommends that the Secretary of the Interior direct the Office of
    Insular Affairs to formally consult with the government of Palau
    regarding Palau�s financial management challenges and assist Palau in
    building financial management capacity. DOI and Palau agreed with GAO�s
    recommendations.

    To view the full product, including the scope and methodology, click on
    [hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-08-732]. For more
    information, contact David Gootnick at (202) 512-3149 or
    gootnickd@gao.gov.

    [End of section]

    Contents:

    Letter:

    Results in Brief:

    Background:

    U.S. Assistance to Palau in 1995-2009 Is Projected at More Than $852
    Million:

    Palau Made Progress in Accountability but Has Limited Capacity to
    Address Internal Control Weaknesses; Interior's Oversight Has Been
    Limited:

    Palau's Prospects for Economic Self-Sufficiency Depend on Multiple
    Factors:

    Conclusions:

    Recommendation for Executive Action:

    Agency Comments and Our Evaluation:

    Appendix I: Objectives, Scope, and Methodology:

    Appendix II: Relevancy of Amendments Made to FSM and RMI Compacts for
    Palau Compact Review:

    Appendix III: Economic Information for Palau:

    Appendix IV: Technical Notes on the Trust Fund Simulation Model:

    Appendix V: Compact Road:

    Appendix VI: Selected Federal Programs:

    Appendix VII: Compact Assistance Provided by the Department of the
    Interior:

    Appendix VIII: Comments from the Department of Interior:

    Appendix IX: Comments from the Republic of Palau:

    Appendix X: GAO Contact and Staff Acknowledgments:

    Tables:

    Table 1: Key Provisions of the Palau Compact of Free Association and
    Related Subsidiary Agreements:

    Table 2: Compact Direct Assistance Provisions and Amounts, 1995-2009:

    Table 3: Compact Federal Services, 1995-2009:

    Table 4: Single Audit Act Report Submissions, 1995-2006:

    Table 5: Financial Statement Audit Opinions for Palau, 1995-2006:

    Table 6: Palau's National Government Finances, 2000-2006:

    Table 7: Economic and Fiscal Data for the Three Compact Countries:

    Table 8: Nominal Returns Distribution Based on Historical Data, 1970-
    2007:

    Table 9: Cross-Correlation and Serial Correlation of Historical Annual
    Returns:

    Table 10: Annual Compounded Returns and Standard Deviations for Large
    Company and Small Company Stocks and for U.S. Treasury Bills (in
    percentage), 1970-2007:

    Table 11: Trial Values of the Palau Trust Fund Balance, 2025-2044:

    Table 12: Historical Rates of Return of a Portfolio Based on the Palau
    Trust Fund Asset Allocation (in percentage):

    Table 13: Discretionary Federal Program Funds Expended in Palau 2006:

    Table 14: Compact Assistance Provided by the Department of the
    Interior, Estimated Payments, 1995-2009:

    Figures:

    Figure 1: Location and Map of Palau:

    Figure 2: Palau National Government Expenditures and Revenues:

    Figure 3: U.S. Assistance to Palau 1995 - 2009 (projected):

    Figure 4: Top Five U.S. Agencies' Expenditures in Palau, 1995 - 2006:

    Figure 5: Palau National Government's Potential Revenues in 2009:

    Figure 6: Palau's Trust Fund Account Balance with Three Rates of Return:

    Figure 7: Probability That Palau Trust Fund Will Be Depleted Given
    Market Volatility, 2010-2044:

    Figure 8: Compact Road at Beginning and End of Construction:

    Figure 9: Map of Palau Roads and States:

    Figure 10: Compact Road Construction Terrain and Cut Slope Failure:

    Figure 11: Compact Road Project Timeline:

    Figure 12: Grass-Cutting Crews and Damaged Guardrail:

    Abbreviations:

    ADB: Asian Development Bank:

    CAT: Civic Action Team:

    DOD: Department of Defense:

    DOT: Department of Transportation:

    Education: Department of Education:

    FAA: Federal Aviation Administration:

    FAC: Federal Audit Clearinghouse:

    FASEG: Freely Associated States Education Grant:

    FSM: Federated States of Micronesia:

    GDP: gross domestic product:

    HHS: Department of Health and Human Services:

    IMF: International Monetary Fund:

    Interior: Department of the Interior:

    OIA: Office of Insular Affairs:

    OIG: Office of the Inspector General:

    OMB: Office of Management and Budget:

    PNCC: Palau National Communications Corporation:

    NWS: National Weather Service:

    RMI: Republic of the Marshall Islands:

    SEPPIE: Special Education Program for Pacific Island Entities:

    State: Department of State:

    USACE: U.S. Army Corps of Engineers:

    USDA: Department of Agriculture:

    USPS: U.S. Postal Service:

    [End of section]

    United States Government Accountability Office:
    Washington, DC 20548:

    June 10, 2008:

    The Honorable Jeff Bingaman:
    Chairman:
    The Honorable Pete V. Domenici:
    Ranking Member:
    Committee on Energy and Natural Resources:
    United States Senate:

    The Honorable Donna M. Christensen:
    Chairwoman:
    The Honorable Luis G. Fortu�o:
    Ranking Member:
    Subcommittee on Insular Affairs:
    Committee on Natural Resources:
    House of Representatives:

    The Compact of Free Association between the Republic of Palau and the
    United States entered into force on October 1, 1994, with the U.S.
    interest of promoting Palau's self-sufficiency and economic
    advancement. The compact and its related subsidiary agreements
    established a 15-year term of economic assistance and specified
    security and defense relations between Palau and the United States.
    Since 1995,[Footnote 1] U.S. aid to Palau has included assistance
    provided for in the compact--direct assistance from 1995 through 2009,
    including investment in a trust fund intended to produce an annual
    distribution of $15 million from 2010 through 2044; federal services;
    and construction of a major road--as well as discretionary federal
    programs.[Footnote 2] The compact's fiscal procedures subsidiary
    agreement[Footnote 3] requires an annual audit of Palau's use of
    compact funds. The agreement also requires Palau to submit economic
    development plans every 5 years, as well as annual reports on, among
    other things, its implementation of these plans. The agreement also
    requires the U.S and Palau governments to hold annual economic
    consultations to review Palau's progress toward self-sufficiency.
    Additionally, the compact's subsidiary trust fund agreement requires
    the U.S. and Palau governments to consult regarding Palau's trust fund
    every 5 years. The Department of the Interior's (Interior) Office of
    Insular Affairs (OIA) has primary responsibility for monitoring and
    coordinating all U.S. assistance to Palau, and the Department of State
    (State) is responsible for government-to-government relations.

    Direct assistance provided under title two of the compact is due to
    expire on September 30, 2009. At that time, Palau's annual withdrawals
    from its trust fund can increase from $5 million to $15 million.
    [Footnote 4] The compact's federal programs and services agreement
    will, unless renewed or extended, also expire on September 30, 2009,
    ending the provision to Palau of three federal services-- postal,
    weather, and aviation. The compact mandates that the governments of the
    United States and Palau review the terms of the compact and its related
    agreements in 2009 and that any modifications be made by mutual
    agreement.

    You asked us to examine (1) the provision of compact and other U.S.
    assistance to Palau in 1995-2009, (2) Palau's and U.S. agencies'
    efforts to provide accountability over Palau's use of federal funds in
    1995-2006, and (3) Palau's prospects for achieving economic self-
    sufficiency. In addition, we provide information on amendments made to
    the United States' compacts with the Federated States of Micronesia
    (FSM) and the Republic of the Marshall Islands (RMI) in 2003 and the
    relevancy of these amendments for Palau (see app. II).

    To address our objectives, we reviewed Palau's compact annual reports,
    Palau's financial statements and internal control reports for 1995-
    2006, compact road project documentation, and economic studies. We
    interviewed officials from Interior; State; and the Departments of
    Agriculture (USDA), Defense (DOD), Education (Education), Health and
    Human Services (HHS), Homeland Security, Labor, and Transportation
    (DOT). In addition, we interviewed officials from the Federal Aviation
    Administration (FAA), the U.S. Postal Service (USPS), the National
    Weather Service (NWS)[Footnote 5] and the U.S. Army Corps of Engineers
    (USACE), as well as economic experts from the International Monetary
    Fund (IMF) and the Asian Development Bank (ADB). In Palau, we
    interviewed government officials from a range of ministries, including
    the ministries of Finance, Health, Education, and Resources and
    Development, and the Office of the Public Auditor. We also met with
    private sector representatives and nongovernmental organizations in
    Palau, and we spoke with Palau's external auditor. We inspected the
    compact road and viewed infrastructure improvements to Palau's airport
    funded by FAA's Airport Improvement Program. We conducted this
    performance audit from October 2007 to June 2008 in accordance with
    generally accepted government auditing standards. Those standards
    require that we plan and perform the audit to obtain sufficient,
    appropriate evidence to provide a reasonable basis for our findings and
    conclusions based on our audit objectives. We believe that the evidence
    obtained provides a reasonable basis for our findings and conclusions
    based on our audit objectives. Appendix I provides more details on our
    objectives, scope, and methodology.

    Results in Brief:

    U.S. aid to Palau in 1995-2009--compact direct assistance,[Footnote 6]
    compact federal services, compact road construction, and discretionary
    federal programs--is expected to exceed $852 million.[Footnote 7]
    Compact direct assistance, providing general budgetary support for
    Palau's government operations, will account for $411 million, or 48
    percent of the assistance provided. Compact federal services--postal,
    weather, and aviation--will account for about $25 million, or 3 percent
    of the assistance, and compact road construction accounted for $149
    million, or 17 percent of the assistance. Palau's receipt of
    discretionary federal program assistance will account for another $267
    million, or 31 percent of the total assistance provided. For 1995-2006,
    five U.S. agencies--Education, HHS, Interior, DOD, and DOT--contributed
    the majority of discretionary federal program assistance to Palau.

    Despite limited capacity to address persistent internal control
    weaknesses, Palau made progress in providing financial accountability
    and met most of the compact's and related agreements' accountability
    requirements; however, OIA provided limited monitoring of Palau's
    accountability for compact assistance. Palau's single audit reports for
    1995-2006 show that it made progress in financial accountability by
    improving its timeliness in submitting the audit reports and improving
    the reliability of its financial statements. At the same time, the
    reports show persistent weaknesses in Palau's internal controls over
    financial reporting; the reports also indicate that Palau has not
    complied with all federal award requirements and show persistent
    weaknesses in Palau's internal control over compliance with these
    requirements. Although Palau has developed plans to correct these
    weaknesses, Palau's controller and Palau's external auditor said that
    limited capacity in financial accounting resources and expertise limits
    Palau's ability to execute these plans in a timely way. These
    weaknesses put Palau at risk of being unable to sustain its
    improvements in financial accountability and to operate a major federal
    program within applicable requirements. Palau met the majority of the
    compact's and related agreements' accountability requirements, such as
    submitting annual reports and economic development plans. OIA and State
    officials, as well as officials from the government of Palau, reported
    that they participated in the economic consultations required by the
    fiscal procedures agreement but that the meetings were not held
    annually. Moreover, U.S. and Palau officials acknowledged that the
    required trust fund consultations were not held at all. According to
    OIA officials, OIA uses Palau's single audit results and compact annual
    reports to monitor Palau's use of compact funds but views its oversight
    role as limited.

    Palau's prospects for economic self-sufficiency depend on four key
    factors: levels of continued U.S. assistance, the availability and
    value of trust fund withdrawals, fiscal reform to reduce Palau's
    dependence on these withdrawals, and private sector growth through an
    improved business environment.

    * U.S. assistance. Given the $10 million scheduled increase in Palau's
    annual trust fund withdrawals in 2010, the expiration of $13.3 million
    in U.S. compact direct assistance at the end of 2009 will likely cause
    a net decline of less than 4 percent in Palau's national government
    revenues. However, potential increases or reductions in future levels
    of discretionary federal programs--estimated at $11.9 million in 2009-
    -could have a significant fiscal impact. In addition, unless the
    federal programs and services agreement is extended by the U.S. and
    Palau governments, Palau will lose postal, weather, and aviation
    services that are estimated to cost U.S. agencies almost $1.6 million
    in 2009.

    * Trust fund withdrawals. A compounded annual return of at least 8.1
    percent will allow Palau to withdraw $15 million per year from its
    trust fund for the planned 35 years. From 1995 through March 2008, the
    Palau trust fund earned a compounded return of 9 percent.[Footnote 8]
    However, market volatility makes it possible that the trust fund will
    be depleted after 2016 even with a favorable long-term average rate of
    earnings. In addition, future inflation will cause the withdrawals to
    lose value over time.

    * Fiscal reform. To decrease its long-term reliance on trust fund
    financing, Palau will require fiscal reforms aimed at closing the gap
    between its revenues and expenditures. Specifically, experts suggest
    that Palau improve its tax income by addressing the problem of weak
    administration and an inefficient income and business tax structure and
    reduce its expenditures through lowering the public sector wage bill.

    * Private sector growth. To promote private sector growth, Palau will
    need to improve its business environment. Currently, restrictive
    foreign investment regulations and practices, deficient financial
    oversight, inadequate access to land, and an inability to attract
    skilled workers raise private sector costs and weaken investment
    incentives.

    To improve Palau's ability to sustain its improvements in financial
    reporting and address its internal control weaknesses, we recommend
    that the Secretary of the Interior direct the Office of Insular Affairs
    to formally consult with the government of Palau regarding Palau's
    financial management challenges and target future technical assistance
    toward building Palau's financial management capacity.

    We provided a draft of this report to the Secretary of the Interior,
    the Secretary of State, and the government of Palau. The Department of
    the Interior agreed with our report and recommendation and said that it
    had begun making plans to implement the recommendation. The government
    of Palau also agreed with our report and recommendation. The Department
    of State did not comment on the report. In addition, we received
    technical comments from USDA, Education, and Homeland Security, as well
    as FAA, NWS, USPS, and the USACE.

    Background:

    U.S. relations with Micronesia began during World War II, when the
    United States ended Japanese occupation of the region. In 1947, the
    United Nations assigned the United States administering authority over
    the Trust Territory of the Pacific Islands, which included Palau and
    other Micronesian island districts. During its administration of the
    trust territory, the United States aided these islands by, among other
    things, building roads, hospitals, and schools; extending eligibility
    for U.S. federal programs; and supporting government operations. The
    trustees eventually sought various forms of independence and today
    comprise four island jurisdictions: the Commonwealth of the Northern
    Mariana Islands, an insular area under the sovereignty of the United
    States, and three Freely Associated States--the Federated States of
    Micronesia (FSM), the Republic of the Marshall Islands (RMI), and the
    Republic of Palau.[Footnote 9] Palau adopted its own constitution in
    1981, and the governments of the United States and Palau concluded a
    Compact of Free Association in 1986, similar to compacts that the
    United States had entered into with the FSM and the RMI. The compact
    entered into force on October 1, 1994, concluding Palau's transition
    from trusteeship to independence. As a sovereign nation, Palau conducts
    its own foreign relations. Palau is a member of the United Nations and
    has bilateral relations with more than 40 countries, including the
    United States and Japan, as well as the European Union. Palau also has
    diplomatic relations with Taiwan.

    Palau's territory of about 190 square miles includes 8 main islands and
    more than 250 smaller islands. As the westernmost cluster of the
    Caroline Islands in the North Pacific Ocean, Palau is located
    approximately 500 miles southeast of the Philippines (see fig. 1).
    Roughly 20,000 people live in Palau, although more than one-quarter of
    the population is non-Palauan. The majority of the population lives in
    the single urban center, Koror, although the capital was officially
    moved in 2006 to Meleokeok, on Babeldaob, Palau's largest island.
    Meleokeok is the seat of Palau's national government, which has an
    executive branch, a legislative branch, and a judicial branch. The
    country is divided into 16 states, each with its own governor and
    legislature.

    Figure 1: Location and Map of Palau:

    This figure is a map of the Far East with an inset map sowing the
    specific location of Palau.

    [See PDF for image]

    Source: GAO, Map Resources (map).

    [End of figure]

    Palau's economy is heavily dependent on its tourism sector and
    substantial foreign aid from the United States, Japan, and Taiwan.
    Since 1994, Palau's economy has grown at a real annual average of 3
    percent; in 2006, Palau's gross domestic product (GDP) was about $154
    million and its GDP per capita was about $7,500.[Footnote 10]
    International visitor arrivals--more than 82,000 in 2006--contributed
    about $97 million to the economy. Similar to many small island
    economies, Palau also receives significant foreign aid, which finances
    a large public sector. In 2006, Palau's national government
    expenditures were $89 million, equivalent to 58 percent of its GDP, and
    the United States and other donors provided grants totaling $44
    million, equivalent to 28 percent of Palau's GDP (see fig. 2).[Footnote
    11] While 2006 national government expenditures exceeded total
    revenues, Palau also has access to financing through interest earned on
    government assets and allowed annual withdrawals on the compact-
    provided trust fund. Palau's government employs about one-third of all
    workers, and the national government wage bill constituted an average
    40 percent of its total expenditures from 2000 to 2006. Palau's private
    sector relies heavily on foreign workers, mostly from the Philippines;
    since 1994, foreign workers[Footnote 12] have grown to account for half
    of Palau's total labor force. Because many of these foreign workers
    send wage income back to their home nations, the annual net outflow of
    remittances from Palau equaled an estimated 5.5 percent of its 2005
    GDP. (For further statistics on Palau's economy and assistance level as
    it compares to other compact nations, see app. III.)

    Figure 2: Palau National Government Expenditures and Revenues:

    This figure contains two pie-charts with associated data tables. The
    following data is depicted:

    2000-2006 Average Expenditure by Type:

    Wage bill: 40%;
    Capital: 21%;
    Other Operating: 39%.

    2006 Expenditure Level:

    Capital:
    Dollars in millions: $22.7;
    Percentage of GDP: 15%.

    Wage bill:
    Dollars in millions: $33.2;
    Percentage of GDP: 22%.

    Other Operating:
    Dollars in millions: $33.4;
    Percentage of GDP: 22%.

    Total:
    2000-2006 Average Revenue by Source:
    Taxes: 39%;
    U.S. Assistance: 35%;
    Other donor assistance: 15%;
    Other domestic: 15%.

    2006 Revenue Level:

    U.S. Assistance:
    Dollars in millions: $31.5;
    Percentage of GDP: 20%.

    Other donor assistance:
    Dollars in millions: $12.8;
    Percentage of GDP: 8%.

    Taxes:
    Dollars in millions: $29.4;
    Percentage of GDP: 19%.

    Other domestic:
    Dollars in millions: $9.6;
    Percentage of GDP: 6%.

    Total:
    Dollars in millions: $83.3;
    Percentage of GDP: 54%.

    Source: GAO estimates based on Palau�s single audit reports.

    [See PDF for image]

    Notes:

    GDP = gross domestic product.

    Figures and tables exclude: (a) component units, such as the Palau
    Community College; (b) in-kind foreign assistance, such as compact
    federal services; and (c) annual net financing, such as Palau's $5
    million trust fund withdrawal from 2002-2006, to pay for the gap
    between revenues and expenditures. Net financing is excluded as a
    revenue source given that the trust fund was designed to provide Palau
    with financing only until 2044, in addition to the market volatility
    associated with investment earnings.

    "Other operating" expenditures include those for goods and services and
    "Other domestic" revenues include fees and charges, licenses, permits,
    and other direct revenues.

    All years cited are fiscal years (Oct. 1-Sept. 30). All dollar amounts
    are in current (i.e., nominal) dollars.

    [End of figure]

    Compact of Free Association:

    The Compact of Free Association between Palau and the United States
    became effective on October 1, 1994,[Footnote 13] with the U.S.
    interest of promoting Palau's self-sufficiency and economic
    advancement. It also established certain national security objectives
    for Palau and the United States. The compact requires the United States
    to provide a 15-year term[Footnote 14] of direct assistance and to set
    up a trust fund with the goal of producing an annual distribution of
    $15 million for 35 years, starting in 2010. The compact also includes
    certain security and defense provisions between the two countries,
    which are binding until 2044 unless amended by mutual consent. Other
    provisions of the compact continue in perpetuity unless mutually
    terminated by the two countries or individually by Palau or the United
    States. The compact mandates that the U.S. and Palau governments
    formally review the terms of the compact and its related agreements on
    the 15th, 30th, and 40th anniversaries of the effective date of the
    compact and mutually agree to any alterations. The first mandated
    review will take place in 2009.

    Table 1: Key Provisions of the Palau Compact of Free Association and
    Related Subsidiary Agreements:

    Compact section: Title one: Government Relations;
    Description of key provisions: Sovereignty: Establishes Palau as a self-
    governing nation with the capacity to conduct its own foreign affairs;
    Immigration privileges: Provides Palauan citizens with certain
    immigration privileges, such as the rights to work and live in the
    United States indefinitely and to enter the United States without a
    visa or passport.

    Compact section: Title two: Economic Relations;
    Description of key provisions: Compact direct assistance: 15-year term
    of budgetary support for Palau, including direct assistance for current
    account operations and maintenance, and for specific needs such as
    energy production, capital improvement projects, health, and education;
    Requires the United States to set up a trust fund for Palau. This
    assistance expires in 2009. Compact road: Requires the United States to
    build a road system for Palau (the "compact road"). Compact federal
    services: Requires the United States to make available certain federal
    services and related programs to Palau, such as postal, weather, and
    aviation services. The compact federal programs and services agreement-
    establishing the legal status of programs and related services, federal
    agencies, U.S. contractors, and personnel of U.S. agencies implementing
    both compact federal services and discretionary federal programs in
    Palau-expires in 2009. Accountability of compact funds: Requires Palau
    to report annually on its use of compact funds. Requires the U.S.
    government, in consultation with Palau, to implement procedures for
    periodic audit of all grants and other assistance.

    Compact section: Title three: Security and Defense Relations;
    Description of key provisions: Establishes that the United States has
    full authority and responsibility for security and defense matters in
    or relating to Palau. Forecloses Palau to the military of any other
    nation except the United States. The United States may establish
    defense sites in Palau and has certain military operating rights.
    Security provisions specified in the subsidiary status of force
    agreement[A] are binding until 2044, 50 years from the effective date
    of the compact, or until the termination of title three of the compact,
    whichever is longer.

    Compact section: Title four: General Provisions;
    Description of key provisions: Establishes general provisions regarding
    approval and effective date of the compact, conference and dispute
    resolution procedures, amendment and review requirements, and compact
    termination procedures.

    Source: GAO analysis of the Compact of Free Association.

    Note: The compact's subsidiary agreements relate to specific titles of
    the compact; in many cases, they contain implementing details of
    compact provisions.

    [A] Status of Forces Agreement Concluded Pursuant to Section 323 of the
    Compact of Free Association.

    [End of table]

    Other U.S. Assistance to Palau:

    In addition to the U.S. assistance provided under the terms of the
    compact, U.S. agencies--Education, HHS, and Interior, among others--
    extend discretionary federal programs to Palau as authorized by U.S.
    legislation, and with funding appropriated by Congress for the
    programs. The federal programs and services agreement--which
    establishes the legal status of programs and related services, federal
    agencies, U.S. contractors, and personnel of U.S. agencies implementing
    both compact federal services and discretionary programs in Palau--
    expires in 2009.

    Key Compact and Related Agreements Accountability Requirements:

    The compact's fiscal procedures agreement states that the U.S.
    government has the authority and responsibility to audit all compact
    funds[Footnote 15] and requires Palau to submit audit reports each year
    on its use of compact funding, within the meaning of the Single Audit
    Act.[Footnote 16] Single audit reports provide key information about
    Palau's financial management and reporting and are an important control
    used by federal agencies for overseeing and monitoring the use of
    federal grants.[Footnote 17] These reports are due at the end of the
    third quarter following the end of the fiscal year under review.
    Interior is designated as the cognizant agency with respect to Palau's
    single audits;[Footnote 18] OIA carries out the responsibilities
    associated with that designation. Interior's Office of the Inspector
    General (OIG) also has audit oversight responsibilities for federal
    funds in Palau. In addition, Palau's Office of the Public Auditor has
    authority to review the government of Palau's use of U.S. federal grant
    funds.[Footnote 19]

    In addition, the compact and related agreements require the Palau and
    U.S. governments to meet other reporting and consultation requirements
    to provide accountability over the use of compact funds.[Footnote 20]
    An executive order regarding the management of the compact assigns
    Interior responsibility for monitoring and coordinating assistance
    provided under the compact and assigns State responsibility for
    government-to-government relations.[Footnote 21]

    * Economic development plans. Palau must submit an overall economic
    development plan to the U.S. government every 5 years, identifying the
    planned annual expenditure of compact assistance.[Footnote 22] The U.S.
    government is required to review each plan in order to ascertain
    compliance and consistency with the requirements of the compact, to
    assist the government of Palau in identifying and evaluating
    appropriate goals and objectives, and to determine what U.S. government
    assistance might be made available to assist Palau in implementing the
    plan.

    * Annual reports. Palau must submit an annual report to the U.S.
    government each year describing Palau's economic activities and
    progress in the previous year. The annual reports are required to
    describe Palau's implementation of its overall economic development
    plan and must include specific information on the use of compact funds
    and comprehensive information on Palau's trust fund.

    * Annual economic consultations.[Footnote 23] The U.S. and Palau
    governments must consult annually regarding the substance of Palau's
    annual reports. Specific topics to be discussed include all matters
    covered in the annual reports, Palau's expenditure of compact funding,
    and recommendations for issues to be addressed in future annual reports.

    * Trust fund consultations. Beginning in 2000, the U.S. and Palau
    governments must consult every 5 years to discuss the performance of
    the trust fund and to evaluate the relationship between the performance
    of the trust fund and the condition of Palau's operating expenditures.
    The two governments are required to take mutually-agreed upon action to
    resolve any issues identified.

    U.S. Assistance to Palau in 1995-2009 Is Projected at More Than $852
    Million:

    The United States' cost of providing assistance to Palau in 1995-2009
    is projected to exceed $852 million. This assistance consists of
    compact direct assistance, compact federal services, compact road
    construction, and discretionary federal programs. The first three forms
    of assistance--compact direct assistance, compact federal services, and
    compact road construction--are mandated by the compact and represent
    approximately 48 percent, 3 percent, and 17 percent, respectively, of
    total projected U.S. assistance for 1995-2009. U.S. agencies provide
    the remaining 31 percent of total assistance through discretionary
    federal programs[Footnote 24] (see fig. 3).

    Figure 3: U.S. Assistance to Palau 1995-2009 (projected):

    This figure is a pie-chart depicting the following data:

    (Dollars in millions):

    Compact direct assistance: 48% ($411.0);
    Discretionary federal programs: 31% ($266.7);
    Compact road: 17% ($149.0);
    Compact federal services: 3% ($25.3).

    Source: GAO analysis.

    [See PDF for image]

    Notes:

    Figure shows funding for fiscal years (Oct. 1-Sept. 30). All dollar
    amounts are in current (i.e., nominal) dollars.

    GAO's calculations of direct compact assistance and the compact road
    are based on Interior's Office of Insular Affairs' actual and estimated
    payments to Palau for 1995-2009, as reported in its budget
    justification to Congress for 2009. Compact federal services are
    estimates of past and future expenditures by the NWS, USPS, and the
    FAA. The calculation of estimated discretionary federal programs is the
    sum of U.S. agency program expenditures as reported in single audits
    for 1995-2006 for the Palau national government and for 1997-2006 for
    the Palau Community Action Agency and the Palau Community College. GAO
    projected U.S. agency program expenditures for 2007-2009. To this, we
    added an estimated cost of DOD's Civic Action Teams for 1995-2009.
    Estimated and projected federal program expenditures do not include the
    value of U.S. loans to Palau. For more details, see app. I.

    [End of figure]

    Compact Direct Assistance:

    Compact direct assistance accounts for roughly half of projected U.S.
    assistance to Palau in 1995-2009, amounting to more than $411 million.
    [Footnote 25] This assistance flows as a direct transfer payment to the
    government of Palau. The compact specifies general purposes for these
    funds but gives the Palau government broad discretion regarding the use
    of these funds.[Footnote 26] Some direct assistance is provided
    annually for a period of 15 years from the effective date of the
    compact (i.e., 1995-2009). However, more than half of the direct
    assistance was provided in the first 3 years of the compact (see app.
    VII), allowing Palau to invest some of these funds to generate
    additional income. All compact direct assistance will terminate in
    2009. Table 2 details the compact's provisions for direct assistance.

    Table 2: Compact Direct Assistance Provisions and Amounts, 1995-2009:

    Compact section: 211(a);
    Description: Current account operations and maintenance; $12 million
    annually for 10 years (1995-2004) and $11 million annually for the next
    5 years (2005-2009). Beginning in 1999, $5 million of this amount shall
    come from the trust fund set up in 211(f);
    Amount provided 1995-2009 (projected): $120 million.

    Compact section: 211(b);
    Description: Energy production self-sufficiency; $2 million annually
    for 14 years (1995-2008);
    Amount provided 1995-2009 (projected): $28 million.

    Compact section: 211(c);
    Description: Communications; $150,000 annually for 15 years (1995-2009)
    for current account operations and maintenance of communications
    systems plus a sum of $1.5 million in 1995 for acquiring communications
    hardware or for another operating or capital account activity as Palau
    selects;
    Amount provided 1995-2009 (projected): $3.75 million.

    Compact section: 211(d);
    Description: Maritime zone surveillance and enforcement, health
    programs, and postsecondary scholarship fund; $631,000 annually for 15
    years (1995-2009);
    Amount provided 1995-2009 (projected): $9.5 million.

    Compact section: 211(e);
    Description: Maritime zone surveillance and enforcement start-up
    activities; One-time contribution of $666,800;
    Amount provided 1995-2009 (projected): $0.7 million.

    Compact section: 211(f);
    Description: Trust fund; $66 million in 1995 plus $4 million in 1997;
    Amount provided 1995-2009 (projected): $70 million.

    Compact section: 212(b);
    Description: Capital account purposes; One-time contribution of $36
    million in 1995;
    Amount provided 1995-2009 (projected): $36 million.

    Compact section: 213;
    Description: Defense use impact fund; One-time contribution of $5.5
    million in 1995;
    Amount provided 1995-2009 (projected): $5.5 million.

    Compact section: 215;
    Description: Inflation adjustment; Yearly adjustment of amounts
    provided in sections 211(a), 211(b), 211(c), and 212(b);
    Amount provided 1995-2009 (projected): $98.9 million.

    Compact section: 221(b) and federal programs and services agreement;
    Description: Special block grants for health and education; $2 million
    annually for 15 years (1995-2009), $4.3 million in 1995, $2.9 million
    in 1996, and $1.5 million in 1997;
    Amount provided 1995-2009 (projected): $38.7 million.

    Compact section: Total direct assistance;
    Amount provided 1995-2009 (projected): $411 million.

    Source: GAO analysis of the Compact of Free Association and OIA budget
    justification 2009.

    Note: All years cited are fiscal years (Oct. 1-Sept. 30). All dollar
    amounts are in current (i.e., nominal) dollars.

    [End of table]

    Palau reported the following uses of compact direct assistance in 1995-
    2006:

    * More than one-quarter of direct assistance was provided to Palau
    under compact section 211(a) as annual budgetary support and used for
    general government operations. According to its compact annual reports,
    Palau distributed its 211(a) funds for uses such as supporting its
    executive, legislative, and judicial branches; independent agencies;
    and in block grants to states. In 2006, for example, Palau allocated $4
    million to its executive branch; $1 million to its independent
    agencies, which includes its Office of the Public Auditor and Office of
    the Special Prosecutor; and $1 million to other agencies and programs,
    which include components such as its Coral Reef Center.

    * The United States provided the entire $28 million of section 211(b)
    funds to Palau in 1995, when the compact went into effect,[Footnote 27]
    enabling Palau to accrue investment earnings on the base sum. According
    to Palau's compact annual reports, the government used 211(b) funds on
    a range of projects to achieve energy self-sufficiency, such as paying
    off its debt on its central power station and improving power systems
    in outlying states. Palau reports that it achieved electrification for
    all of its 16 states by 1999; states receive electricity from one of
    Palau's two main power stations or from the island states' alternate
    sources.

    * Palau used section 211(c) assistance primarily for public
    broadcasting operations and 211(d) and 211(e) funds for purposes such
    as patrol boat operations, education scholarships, and medical supplies.

    * Section 211(f) of the compact required the United States to establish
    a trust fund for Palau with an initial investment of $70 million by the
    compact's third year. In accordance with terms of the trust fund
    agreement, since 1999, $5 million of annual 211(a) assistance has been
    available from the trust fund, although Palau did not begin taking this
    disbursement until 2002.

    * As specified in section 212(b), Palau received $36 million in fiscal
    year 1995 for capital account purposes. Funding was spent for purposes
    such as improvements to Palau's water system and national roads;
    rehabilitation of a power plant and schools; and construction of a
    national gymnasium, four health dispensaries, and education facilities.
    Palau also passed some of this funding to state governments for state-
    directed capital improvement projects.

    * Funding for section 211(a), as well as the assistance granted in
    sections 211(b), 211(c), and 212(b), was increased because of the
    inflation adjustment dictated in section 215.[Footnote 28] Inflation
    adjustment for these four sections will account for an additional $99
    million in assistance by 2009.

    * In 1997-2006, the Palau national government transferred the $2
    million provided annually under section 221(b) of the compact for
    health and education purposes to the Palau Community College for its
    operations.

    Compact Federal Services:

    The compact provides for federal postal, weather, and aviation services
    in Palau at a level equivalent to the services provided the year before
    the compact was implemented.[Footnote 29] The federal programs and
    services agreement describes the provisions of each of these services.
    This agreement remains in force for 15 years from the effective date of
    the compact; as a result, U.S. provision of these three federal
    services will expire in 2009 unless the agreement is renewed or
    extended. U.S. agencies providing these services--USPS, NWS, and FAA--
    incur costs in doing so, but in some cases, the United States receives
    a reciprocal benefit.

    Table 3: Compact Federal Services, 1995-2009:

    Federal service: Postal service;
    U.S. agency providing service: U.S. Postal Service;
    Estimated expenditures by U.S. agency providing service 1995-2009
    (projected): $12.3 million.

    Federal service: Weather service;
    U.S. agency providing service: National Weather Service;
    Estimated expenditures by U.S. agency providing service 1995-2009
    (projected): $8.6 million.

    Federal service: Aviation service;
    U.S. agency providing service: Federal Aviation Administration;
    Estimated expenditures by U.S. agency providing service 1995-2009
    (projected): $4.4 million.

    Federal service: Total;
    Estimated expenditures by U.S. agency providing service 1995-2009
    (projected): $25.3 million.

    Source: GAO analysis of estimates provided by USPS, NWS, and FAA.

    Note: All years cited are fiscal years (Oct. 1-Sept. 30). All dollar
    amounts are in current (i.e., nominal) dollars.

    [End of table]

    USPS conveys mail[Footnote 30] between the United States and Palau and
    offers other services such as Priority Mail�, cash-on-delivery, and
    postal money orders. USPS charges U.S. domestic postal rates[Footnote
    31] for mail sent between the United States and Palau. The government
    of Palau retains the revenue from stamps purchased in Palau, while USPS
    retains revenue from stamps purchased in the United States. USPS
    officials said that the postage charged does not reflect the real cost
    of conveying mail to Palau, especially with rising transportation
    costs.[Footnote 32] USPS is reimbursed by Interior for providing postal
    services to Palau; however, according to USPS officials, the amount
    reimbursed is less than the total cost of service. This loss is reduced
    by USPS's revenue collected on stamps for Palau-bound mail purchased in
    the United States. In addition to transporting mail, USPS provides
    technical assistance to Palau's postal service and has made several
    donations of used equipment, such as mail trucks.

    NWS reimburses Palau for the cost of operating its weather station in
    Palau. The weather station in Palau performs upper air observations
    twice daily with a weather balloon as well as additional weather
    observations on request. The station and the equipment are maintained
    by Palauan staff, which includes two meteorologists whose professional
    training was sponsored by NWS. The weather forecasts produced by the
    weather station are essential to Palau's airport operations. The
    station's observations are important to NWS in helping to predict
    cyclones and other violent weather traveling eastward from Palau toward
    U.S. territories such as Guam.

    FAA provides aviation services[Footnote 33] to Palau, including en-
    route air traffic control from the mainland United States, flight
    inspection of airport navigation aids, and technical assistance and
    training.

    Compact Road:

    The compact required the United States to build a road system in Palau
    based on specifications mutually agreed with the government of Palau.
    Interior's OIA budgeted $149 million for the project. While the compact
    required the road to be completed by October 1, 2000, the project
    incurred several planning and construction delays and was not completed
    until October 1, 2007. When the road was completed, Palau accepted
    responsibility for its operation and maintenance. Palau has made
    efforts to maintain the road; however, both U.S. and Palau officials
    have concerns regarding Palau's ability to maintain the road in a
    condition that will allow for the desired economic development. See
    appendix V for more information on the compact road.

    Discretionary Federal Programs:

    Discretionary federal programs are projected to contribute
    approximately $266.7 million, or 31 percent, of total U.S. assistance
    to Palau between 1995 and 2009. Discretionary federal programs, which
    include federal grants, in-kind services, and loans provided by U.S.
    agencies, assist Palau in areas such as education, health,
    infrastructure improvement, and telecommunications. In 1995-2006, more
    than 14 U.S. agencies provided Palau federal grants and other in-kind
    services worth approximately $203 million.[Footnote 34] Five agencies
    contributed the majority of discretionary assistance to Palau (see fig.
    4). Most of the federal grants awarded to Palau go to the national
    government; two other recipients are the Palau Community College and
    the Palau Community Action Agency, a nonprofit organization. Palau's
    national government spent approximately $132 million, or 73.6 percent
    of the $180 million, of the federal grants awarded to these three
    entities in 1995-2006.

    Figure 4: Top Five U.S. Agencies' Expenditures in Palau, 1995-2006:

    This figure is a pie-chart depicting the following data:

    Top Five U.S. Agencies' Expenditures in Palau, 1995-2006:
    Education: $28% ($56.2 million);
    HHS: 25% ($51.6 million);
    Interior: 19% ($39.1 million);
    DOD: 12% ($23.8 million);
    Other agencies: 10% ($19.8);
    DOT: 6% ($12.9).

    Source: GAO analysis.

    [See PDF for image]

    Notes:

    Figure shows expenditures for fiscal years (Oct. 1-Sept. 30). All
    dollar amounts are in current (i.e., nominal) dollars.

    For all agencies, with the exception of DOD, our analysis used
    expenditure information reported in the single audits from the Palau
    national government, the Palau Community College, and the Palau
    Community Action Agency. GAO estimated DOD's expenditures for its Civic
    Action Team operating costs based on information provided by DOD
    officials. This figure does not include the value of other in-kind
    assistance provided by DOD or any other U.S. agency and it does not
    include the value of U.S. loans extended to Palau.

    [End of figure]

    * The U.S. Department of Education provided federal grants to both the
    national government of Palau and to the Palau Community College, an
    accredited, postsecondary vocational and academic institution.[Footnote
    35] These grants provided funding for a number of education services,
    including special and adult education programs, teacher training and
    curriculum development, and postsecondary financial aid. For example,
    approximately 550 of the 600 students at the Palau Community College
    receive Pell Grants, which were worth approximately $2.2 million in
    2006. Other programs extended to Palau include Education's TRIO
    programs: Upward Bound, Upward Bound Math and Science, and Talent
    Search.[Footnote 36]In 2006, 110 students participated in the Upward
    Bound program, which was worth approximately $360,000.[Footnote 37]

    * HHS supported Palau's Ministry of Health, particularly its Bureau of
    Public Health, with grant programs that fund a health clinic program, a
    family planning program, and immunization programs. HHS also provided
    federal grants to the Palau Community Action Agency, a private,
    nonprofit organization that runs the Head Start program in Palau.
    [Footnote 38] According to Palau government officials, children are
    required to begin their education at 6 years of age; Head Start
    provides the primary early-childhood education and health program for
    children aged 3 to 5 years. The Palau Community Action Agency runs 13
    Head Start education centers throughout Palau and receives funding for
    an enrollment of 509 children.

    * Interior's OIA has provided a number of grants to Palau, including
    funding to cover the cost of Palau's single audit and technical
    assistance grants to provide training and support to finance and budget
    officials, the Public Auditor's office, and the Bureau of Lands and
    Survey. In addition, Interior has provided funds for emergency repairs
    to the national hospital and in support of infrastructure development
    through the Airport Improvement Program.

    * DOD provided in-kind service assistance to Palau through its Civic
    Action Team (CAT). The CAT program consists of teams of 13 service men
    and women, primarily engineers, stationed in Palau for 6-month
    rotations. These teams provide assistance in the following four areas:
    (1) construction, (2) apprentice training, (3) community relations, and
    (4) a medical program.

    * DOT provided a $26 million, 4-year grant (2003-2007) to Palau as part
    of the FAA's Airport Improvement Program. It enhanced the safety and
    capability of Palau's airport by rehabilitating the runway, purchasing
    fire fighting equipment, and installing perimeter security fencing.

    * Ten other agencies extended federal grants to Palau in 1995-2006. For
    example, the Department of Labor provided Workforce Investment Act
    funds to help finance job training and career development programs, and
    USDA extended forestry grant programs.

    See appendix VI for more information regarding selected discretionary
    federal programs.

    In addition to the federal grants and DOD CAT program costs enumerated
    in figure 4, U.S. agencies have provided a range of other assistance
    [Footnote 39] to Palau to assist with maritime surveillance, disaster
    relief, education, and telecommunications. For example, DOD provided
    surveillance assistance to Palau to facilitate and enhance joint
    fisheries surveillance and enforcement. According to agency officials,
    DOD also has the authority to assist with natural disasters in Palau.
    The Peace Corps has had a presence in Palau since 1966 and currently
    has 13 volunteers stationed there to assist in education programs
    primarily at public schools throughout the country.[Footnote 40] The
    United States also has extended development loans to Palau.[Footnote
    41] USDA Rural Development provided subsidized loans to Palau through
    its utilities and housing programs. Through the utilities program, a
    $39 million loan was provided in 1992 to the Palau National
    Communications Corporation to improve the telecommunications
    infrastructure in Palau. (For more information about this loan, see
    app. VI.) USDA's Rural Housing program provided 102 loans, worth over
    $3.1 million, to individuals and families for the purchase or repair of
    their home in 1998-2007.

    Palau Made Progress in Accountability but Has Limited Capacity to
    Address Internal Control Weaknesses; Interior's Oversight Has Been
    Limited:

    Palau's more recent single audit reports show that it made progress in
    financial accountability by improving its timeliness in submitting the
    audit reports. The recent single audit reports also show that Palau has
    improved the reliability of its financial statements. However, the
    reports show persistent weaknesses in Palau's internal control over
    financial reporting. Additionally, the reports indicate that Palau has
    not complied with all federal award requirements and has weaknesses in
    its internal control over compliance with federal award requirements.
    However, limited capacity in financial accounting resources and
    expertise hinders Palau's ability to address these weaknesses in a
    timely way. As a result, Palau is at risk of being unable to sustain
    its improvements in financial accountability and to operate a major
    federal program according to applicable requirements. Palau met the
    majority of the compact's and related agreements' reporting
    requirements for accountability over compact funds, but Palau and the
    U.S. government did not meet all of the consultation requirements.
    Interior's oversight of Palau's accountability for assistance provided
    under the compact was limited.

    Palau's Single Audits Show Improved Financial Accountability but Also
    Persistent Internal Control Weaknesses that Palau Has Limited Capacity
    to Address:

    The Palau national government has improved its financial accountability
    in terms of the timeliness of its single audit report submissions. In
    addition, Palau's recent single audit reports show progress in
    improving the reliability of its financial statements. However, the
    reports also show persistent weaknesses in Palau's internal control
    over financial reporting. In addition, Palau's single audit reports
    show long-standing weaknesses in its internal control over compliance
    with laws and regulations governing federal awards. Although Palau has
    developed plans to correct its internal control weaknesses, its
    capacity to execute these plans in a timely manner is limited. As a
    result, Palau is at risk of being unable to sustain its improved
    financial accountability.

    Palau's Timeliness in Submitting Single Audit Reports Has Improved:

    Palau's timeliness in submitting single audit reports has improved in
    recent years. Although Palau submitted its single audit reports for
    1998-2004 after the established deadlines,[Footnote 42]Palau submitted
    reports for 2005 and 2006 on time.[Footnote 43] (See table 4.) Timely
    submission of single audit reports gives U.S. agencies current
    knowledge of the Palau government's ability to account for federal
    grant monies received and current knowledge of the government's
    internal control and compliance challenges.

    Table 4: Single Audit Act Report Submissions, 1995-2006:

    Year: 1995;
    Number of months late: N/A[A].

    Year: 1996;
    Number of months late: N/A[A].

    Year: 1997;
    Number of months late: 0.

    Year: 1998;
    Number of months late: 2.

    Year: 1999;
    Number of months late: 3.

    Year: 2000;
    Number of months late: 29.

    Year: 2001;
    Number of months late: 4.

    Year: 2002[B];
    Number of months late: 23.

    Year: 2003;
    Number of months late: 11.

    Year: 2004;
    Number of months late: 6.

    Year: 2005;
    Number of months late: 0.

    Year: 2006;
    Number of months late: 0.

    Sources: OMB Circular No. A-133, auditors' reports, Federal Audit
    Clearinghouse, and GAO analysis.

    Note: All years cited are fiscal years (Oct. 1-Sept. 30).

    [A] The Federal Audit Clearinghouse started receiving the Single Audit
    form (SF-FAC) in 1997; therefore, we are unable to determine the
    timeliness of the SF-FAC submission for 1995 and 1996. See GAO, Single
    Audit: Update on the Implementation of the Single Audit Act Amendments
    of 1996, GAO/AIMD-00-293 (Washington, D.C.: September 2000).

    [B] The 2002 Single Audit report was reissued on May 23, 2005.

    [End of table]

    Palau Has Improved Financial Statements' Reliability but Lacks Capacity
    to Address Internal Control Weaknesses:

    For 1995-2002, Palau received qualified audit opinions on its
    government's financial statements, indicating that significant issues
    prevented the auditor from concluding that the financial statements
    were reliable overall.[Footnote 44] However, for 2003-2006, Palau's
    financial statements consistently received unqualified audit opinions,
    indicating that the auditor considered the statements reliable. (See
    table 5.)

    Table 5: Financial Statement Audit Opinions for Palau, 1995-2006:

    Year: 1995;
    Opinion on financial statements: Qualified.

    Year: 1996;
    Opinion on financial statements: Qualified.

    Year: 1997;
    Opinion on financial statements: Qualified.

    Year: 1998;
    Opinion on financial statements: Qualified.

    Year: 1999;
    Opinion on financial statements: Qualified.

    Year: 2000;
    Opinion on financial statements: Qualified.

    Year: 2001;
    Opinion on financial statements: Qualified.

    Year: 2002;
    Opinion on financial statements: Qualified.

    Year: 2003;
    Opinion on financial statements: Unqualified.

    Year: 2004;
    Opinion on financial statements: Unqualified.

    Year: 2005;
    Opinion on financial statements: Unqualified.

    Year: 2006;
    Opinion on financial statements: Unqualified.

    Source: Palau national government's single audit reports for 1995-2006.

    Note: All years cited are fiscal years (Oct. 1-Sept. 30).

    [End of table]

    Despite the improved reliability of its financial statements, Palau has
    long-standing and significant weaknesses in its internal control over
    financial reporting.[Footnote 45] Palau's 2006 single audit report
    cited a number of significant weaknesses in basic internal control that
    impact its financial reporting, many of which were cited in previous
    audit reports.[Footnote 46] These weaknesses include, for example,
    nonresolution of differences in monthly bank reconciliations and a lack
    of policies and procedures for reconciling accounts receivable and
    prepayments.

    Palau has developed corrective action plans to address these
    weaknesses, such as improving reconciliations to ensure proper entries
    and adjustments. Palau also is updating its financial reporting
    policies and procedures, which, according to officials from Palau's
    Ministry of Finance, date back to 1983. However, according to Palau's
    controller and Palau's current external auditor, Palau has inadequate
    staff and expertise to properly address its financial reporting
    weaknesses and make other necessary improvements in a timely manner.
    For example, Palau relies heavily on one individual to prepare its
    financial statements and has had difficulty in hiring a Chief of
    Finance and Accounting. As a result, Palau is at risk of being unable
    to sustain the improvements it has made in its financial accountability.

    Palau Has Weaknesses in Its Compliance with Federal Award Requirements
    and Lacks Capacity to Address These Weaknesses:

    Since 1995, Palau's single audits have consistently received qualified
    opinions on its compliance with federal award requirements owing to
    long-standing and significant internal control weaknesses over its
    compliance with such requirements.[Footnote 47] These weaknesses could
    adversely affect Palau's ability to operate a major federal program
    within the applicable requirements of laws, regulations, contracts, and
    grants. For example, in 2006, Palau's auditor cited noncompliance and
    internal control weaknesses in areas such as procurement, cash
    management, and equipment and real property management.[Footnote 48]
    Many of the problems noted in the 2006 report were recurring. For
    instance, the weakness involving lack of effective controls to ensure
    that property is adequately safeguarded from loss, damage, or theft,
    had existed since 1988.[Footnote 49]

    Palau has developed corrective action plans to address the 2006 single
    audit findings regarding its compliance with, as well as its internal
    control over compliance with, federal grant requirements. For example,
    according to the 2006 report, Palau plans to strengthen internal
    controls over procurement and address its long-standing weaknesses
    related to adequately accounting for its equipment and real
    property.[Footnote 50] However, Palau's limited staff and expertise
    hinder its ability to address the single audit report's findings in a
    timely manner.

    Most Compact-related Reporting Requirements Were Met but Consultation
    Requirements Were Not, and Interior's Oversight Was Limited:

    Palau met the majority of the compact's and related agreements'
    reporting requirements. Palau and U.S. officials reported meeting some
    consultation requirements but in most cases did not document their
    compliance. In addition, Interior's OIA and OIG made efforts to assist
    or oversee Palau's accountability for compact funds; however, according
    to agency officials, OIA viewed its oversight role as limited and
    informal.

    * Economic development plans. Palau prepared a two-volume economic
    development plan for 1995-1999. It updated this plan with an economic
    study for 2000-2005, which was completed by the Japan International
    Cooperation Agency. According to an official from Palau's Ministry of
    Finance, the next plan is expected to be completed at the end of 2008.
    An Interior official said that several U.S. agencies, including State
    and Interior, provided comments to Palau on its initial economic
    development plan.

    * Annual reports. Palau completed the required annual reports and
    submitted them to the U.S. government. According to an Interior
    official, although the agency has reviewed the annual reports, Interior
    has not issued any formal written responses to Palau. As a result,
    there is no documentation regarding whether the U.S. government
    compared the actual use of the compact funds in the preceding year with
    the projected amount or whether the U.S. government agreed or disagreed
    that Palau used compact funds as set forth in its economic development
    plan.

    * Annual economic consultations. Officials from the government of
    Palau, as well as OIA and State officials, told us that the U.S. and
    Palau governments held the required economic consultations.[Footnote
    51] However, the officials said that the meetings were informal and
    that they did not produce any written documentation, such as minutes,
    as a result of the meetings. State and OIA officials acknowledged that
    the meetings did not occur on an annual basis and that they usually
    occurred when other meetings between the two countries took place. An
    OIA official told us that the consultations usually lasted about a half-
    day. Although the compact does not require the Palau and U.S.
    governments to produce written documentation as a result of the
    consultations, the lack of documentation prevents any assessment of the
    meetings' effectiveness. Furthermore, the lack of documentation makes
    it impossible to ascertain whether these informal consultations
    resulted in any recommendations, which the fiscal procedures agreement
    requires to be produced to the maximum extent possible.

    * Trust fund consultations. Officials from the government of Palau and
    from OIA stated that trust fund consultations, required to occur at 5-
    year intervals, did not take place. Because the trust fund
    consultations did not take place, Palau may have lost the opportunity
    to discuss concerns about its trust fund with the United States. For
    example, officials in Palau told us that they interpreted the compact
    and related agreements as prohibiting trust fund managers from
    investing in anything other than U.S. securities. However, the trust
    fund agreement states that the United States government, in
    consultation with the government of Palau, shall consider designating
    other investment-grade instruments as qualified in order that the
    fund's performance objectives are met. If the trust fund consultations
    had taken place, the government of Palau could have raised this issue.

    Interior's OIA and OIG reported efforts to assist or oversee Palau's
    accountability for federal funds. According to Interior officials, it
    has monitored Palau's progress in completing and issuing its single
    audit reports; used Palau's single audit and compact annual reports to
    monitor Palau's use of compact funds; worked with Palau to track single
    audit findings and resolve issues; and, considered Palau's requests to
    extend its single audit submission deadlines. In addition, according to
    Interior officials, OIA has provided general technical assistance funds
    to train Palau employees as well as funds to enhance Palau's financial
    management systems and processes. Interior officials also noted that
    Interior's OIG reviewed the single audit reports to determine whether
    they met applicable reporting standards and requirements.

    However, an OIA official said that its oversight of compact funding has
    not been extensive, because compact assistance is given to Palau with
    the full faith and credit of the United States and because the compact
    gives Palau broad discretion in compact spending. In a 2006 memorandum,
    Interior's OIG criticized OIA for its minimal oversight and monitoring
    of Palau's compact funding. Although the memorandum did not contain
    recommendations, it suggested that OIA commit additional resources,
    such as a full-time staff member, to oversee accountability for compact
    funds and any other U.S. assistance provided to Palau.

    Palau's Prospects for Economic Self-Sufficiency Depend on Multiple
    Factors:

    Palau's prospects for long-term economic self-sufficiency depend on at
    least four factors: levels of continued U.S. assistance, the
    availability and value of trust fund withdrawals, fiscal reform to
    reduce Palau's long-term dependence on these withdrawals, and private
    sector growth through an improved business environment. Regarding
    continued U.S. assistance, given the scheduled increase in Palau's
    annual trust fund withdrawals in 2010, the expiration of compact direct
    assistance at the end of 2009 will likely cause a net decline of less
    than 4 percent in the Palau national government's revenues. Potential
    increases or reductions in the future levels of discretionary federal
    programs could have a significant fiscal impact. Moreover, unless the
    federal programs and services agreement is extended beyond 2009, Palau
    will lose postal, weather, and aviation services. Regarding the trust
    fund withdrawals, a compounded annual return of at least 8.1 percent
    will allow Palau to withdraw $15 million per year from its trust fund
    for the planned 35 years; however, market volatility makes it
    increasingly probable that the trust fund will be depleted after 2016,
    and inflation will cause the withdrawals to lose value over time. To
    decrease its reliance on trust fund financing, Palau will require
    fiscal reforms to close the gap between its revenues and expenditures.
    Regarding private sector growth, Palau will need to improve its
    business environment by addressing problems with its foreign investment
    climate; financial system; and land, labor, and commercial policies
    that presently discourage such growth.

    Prospects for Economic Self-sufficiency Depend on Levels of Continuing
    U.S. Assistance:

    Palau's prospects for economic self-sufficiency depend in part on
    levels of continuing discretionary federal program assistance. We
    estimate that in 2009, the Palau national government's potential
    revenues--compact direct assistance, discretionary federal programs,
    other donor assistance, and domestic revenues[Footnote 52]--will total
    about $87 million (see fig. 5). Domestic revenues, at about $44 million
    in 2009, will have grown from about $30 million in 2000, based on the
    annual growth rate of 4.4 percent from 2000-2006. Other donor
    assistance, at about $18 million in 2009, will have grown from about $6
    million in 2000, based on its annual growth rate of 17.4 percent from
    2000-2006. In addition to potential revenues, Palau's government also
    will have access to financing through earned interest and annual
    withdrawals from the U.S. trust fund and other government assets. (For
    further fiscal information on Palau's national government, see app.
    III.)

    Figure 5: Palau National Government's Potential Revenues in 2009:

    [See PDF for image]

    This figure is a stacked vertical bar graph depicting the following
    data:

    Palau National Government's Potential Revenues in 2009:
    Domestic revenue: $43.6 million;
    Other donor assistance: $17.8 million;
    Discretionary federal programs: $11.9 million (Discretionary federal
    program annual levels based on eligibility);
    Compact direct assistance: $13.3 million (Compact direct assistance
    expires at the end of 2009);
    Total: $86.6 million.

    Source: GAO analysis.

    Notes:

    Years cited are fiscal years (Oct. 1-Sept. 30). All dollar amounts are
    in current (i.e., nominal) dollars.

    Domestic revenue includes taxes, fees and charges, licenses and
    permits, and other direct revenues and excludes net investment
    earnings. Total revenues exclude revenues for component units and in-
    kind assistance, such as compact federal services. In addition to
    revenues, Palau will have access to financing, including a $5 million
    annual trust fund withdrawal. Further fiscal information is provided in
    app. III.

    To estimate potential 2009 domestic revenue and the level of other
    donor assistance, we reviewed Palau single audit data for 2000-2006 and
    Palau budgets for 2007 and 2008 and applied the average annual growth
    rate from 2000-2008.

    Discretionary federal programs exclude the value of DOD's Civic Action
    Team program that is provided in kind. To estimate potential 2009
    discretionary federal program levels, we reviewed Palau budget data for
    2008 and assumed the same level of federal programs would be provided
    in 2009, adjusted for inflation.

    The 2009 level of compact direct assistance is based on U.S. agency
    budget data.

    [End of figure]

    Although the expiration of compact direct assistance at the end of 2009
    will reduce the national government's revenues by about $13.3 million,
    Palau will gain access to an additional $10 million in annual financing
    when its yearly trust fund withdrawals increase in 2010 from $5 million
    to $15 million. As a result, the net fiscal impact of expiring compact
    direct assistance will be about $3.3 million annually, or less than 4
    percent of the national government's revenues in 2009. However, levels
    of other forms of U.S. assistance after 2009 will impact Palau's fiscal
    condition:

    * Discretionary federal programs. Since most federal programs operating
    in Palau are discretionary, they supply varied levels of annual
    assistance. For example, discretionary federal program assistance to
    the national government grew from $7.3 million in 2000 to $18.8 million
    in 2006, but is expected to fall to $11.3 million in 2008.[Footnote 53]
    Although discretionary federal program funding in 2009 could total
    almost $12 million, or 14 percent of the national government revenues,
    future program funding will depend on Palau's program eligibility
    status and the availability of appropriations. Palau's eligibility for
    some federal programs may expire, absent affirmative action by
    Congress. In addition, the expiration of the compact's federal programs
    and services agreement in 2009 may impact U.S. agencies' implementation
    of discretionary federal programs in Palau. However, U.S. agency
    officials we interviewed expressed uncertainty about the extent of any
    such impact.

    * Compact federal services. If compact federal services expire as
    scheduled at the end of 2009, the Palau national government may seek to
    provide these services with its own revenues. For example, unless the
    federal programs and services agreement is renewed or extended, Palau
    will lose postal, weather, and aviation services that are estimated to
    cost U.S. agencies almost $1.6 million in 2009.

    Prospects for Economic Self-sufficiency Depend on Availability and
    Value of Trust Fund Withdrawals:

    Palau's prospects for economic self-sufficiency also depend in part on
    the availability of the planned $15 million annual trust fund
    withdrawals and the value of those withdrawals over time. Palau will be
    able to withdraw $15 million per year from its trust fund for the
    planned 35 years--from 2010 through 2044--if the fund earns a
    compounded annual return of at least 8.1 percent.[Footnote 54] To grow
    in perpetuity, the trust fund must earn a compounded return rate of 8.6
    percent or higher. Both of these rates are lower than the 9 percent
    return that the trust fund has earned from its inception in 1995
    through March 2008; however, forecasts of future returns are subject to
    considerable uncertainty. The historical rate of return for the asset
    classes held in the fund's portfolio differ depending on the time
    period considered. For example, the compounded rate of return was 8.1
    percent for 1926-2007, 9.1 percent for 1970-2007, and 5.2 percent for
    1998-2007.[Footnote 55] If the trust fund continues to earn the 9
    percent annual return it has earned thus far, or any rate equal to or
    greater than 8.6 percent, the trust fund will likely grow in perpetuity
    from its balance as of March 2008 (see fig. 6).

    Figure 6: Palau's Trust Fund Account Balance with Three Rates of Return
    (Dollars in millions):

    [See PDF for image]

    The Palau trust fund had a balance of $160.775 million as of March
    2008.

    This figure is a multiple line graph depicting the following data:

    Fiscal year: 2008;
    Palau Trust Fund Balance, 9.0% (the compound rate of return Palau trust
    fund earned from inception to March 2008): $173.2;
    Palau Trust Fund Balance, 8.6% (rate of return needed to grow the trust
    fund in perpetuity): $172.4
    Palau Trust Fund Balance, $8.1% (rate of return needed to sustain the
    trust fund for 35 years): $171.5.

    Fiscal year: 2009;
    Palau Trust Fund Balance, 9.0% (the compound rate of return Palau trust
    fund earned from inception to March 2008): $183.7;
    Palau Trust Fund Balance, 8.6% (rate of return needed to grow the trust
    fund in perpetuity): $181.9
    Palau Trust Fund Balance, 8.1% (rate of return needed to sustain the
    trust fund for 35 years): $180.1.

    Fiscal year: 2010;
    Palau Trust Fund Balance, 9.0% (the compound rate of return Palau trust
    fund earned from inception to March 2008): $184.7;
    Palau Trust Fund Balance, 8.6% (rate of return needed to grow the trust
    fund in perpetuity): $181.9;
    Palau Trust Fund Balance, 8.1% (rate of return needed to sustain the
    trust fund for 35 years): $179.1.

    Fiscal year: 2011;
    Palau Trust Fund Balance, 9.0% (the compound rate of return Palau trust
    fund earned from inception to March 2008): $185.9;
    Palau Trust Fund Balance, 8.6% (rate of return needed to grow the trust
    fund in perpetuity): $181.9;
    Palau Trust Fund Balance, 8.1% (rate of return needed to sustain the
    trust fund for 35 years): $177.9.

    Fiscal year: 2012;
    Palau Trust Fund Balance, 9.0% (the compound rate of return Palau trust
    fund earned from inception to March 2008): $187.1;
    Palau Trust Fund Balance, 8.6% (rate of return needed to grow the trust
    fund in perpetuity): $181.9;
    Palau Trust Fund Balance, 8.1% (rate of return needed to sustain the
    trust fund for 35 years): $176.7.

    Fiscal year: 2013;
    Palau Trust Fund Balance, 9.0% (the compound rate of return Palau trust
    fund earned from inception to March 2008): $188.5;
    Palau Trust Fund Balance, 8.6% (rate of return needed to grow the trust
    fund in perpetuity): $181.9;
    Palau Trust Fund Balance, 8.1% (rate of return needed to sustain the
    trust fund for 35 years): $175.4.

    Fiscal year: 2014;
    Palau Trust Fund Balance, 9.0% (the compound rate of return Palau trust
    fund earned from inception to March 2008): $189.9;
    Palau Trust Fund Balance, 8.6% (rate of return needed to grow the trust
    fund in perpetuity): $181.9;
    Palau Trust Fund Balance, 8.1% (rate of return needed to sustain the
    trust fund for 35 years): $173.9.

    Fiscal year: 2015;
    Palau Trust Fund Balance, 9.0% (the compound rate of return Palau trust
    fund earned from inception to March 2008): $191.6;
    Palau Trust Fund Balance, 8.6% (rate of return needed to grow the trust
    fund in perpetuity): $181.9;
    Palau Trust Fund Balance, 8.1% (rate of return needed to sustain the
    trust fund for 35 years): $172.4.

    Fiscal year: 2016;
    Palau Trust Fund Balance, 9.0% (the compound rate of return Palau trust
    fund earned from inception to March 2008): $193.3;
    Palau Trust Fund Balance, 8.6% (rate of return needed to grow the trust
    fund in perpetuity): $181.9;
    Palau Trust Fund Balance, 8.1% (rate of return needed to sustain the
    trust fund for 35 years): $170.8.

    Fiscal year: 2017;
    Palau Trust Fund Balance, 9.0% (the compound rate of return Palau trust
    fund earned from inception to March 2008): $195.2;
    Palau Trust Fund Balance, 8.6% (rate of return needed to grow the trust
    fund in perpetuity): $181.9;
    Palau Trust Fund Balance, 8.1% (rate of return needed to sustain the
    trust fund for 35 years): $170.0.

    Fiscal year: 2018;
    Palau Trust Fund Balance, 9.0% (the compound rate of return Palau trust
    fund earned from inception to March 2008): $197.3;
    Palau Trust Fund Balance, 8.6% (rate of return needed to grow the trust
    fund in perpetuity): $181.9;
    Palau Trust Fund Balance, 8.1% (rate of return needed to sustain the
    trust fund for 35 years): $167.1.

    Fiscal year: 2019;
    Palau Trust Fund Balance, 9.0% (the compound rate of return Palau trust
    fund earned from inception to March 2008): $199.6;
    Palau Trust Fund Balance, 8.6% (rate of return needed to grow the trust
    fund in perpetuity): $181.9;
    Palau Trust Fund Balance, 8.1% (rate of return needed to sustain the
    trust fund for 35 years): $164.9.

    Fiscal year: 2020;
    Palau Trust Fund Balance, 9.0% (the compound rate of return Palau trust
    fund earned from inception to March 2008): $202.1;
    Palau Trust Fund Balance, 8.6% (rate of return needed to grow the trust
    fund in perpetuity): $181.9;
    Palau Trust Fund Balance, 8.1% (rate of return needed to sustain the
    trust fund for 35 years): $162.7.

    Fiscal year: 2021;
    Palau Trust Fund Balance, 9.0% (the compound rate of return Palau trust
    fund earned from inception to March 2008): $204.8;
    Palau Trust Fund Balance, 8.6% (rate of return needed to grow the trust
    fund in perpetuity): $181.9;
    Palau Trust Fund Balance, 8.1% (rate of return needed to sustain the
    trust fund for 35 years): $160.3.

    Fiscal year: 2022;
    Palau Trust Fund Balance, 9.0% (the compound rate of return Palau trust
    fund earned from inception to March 2008): $207.7;
    Palau Trust Fund Balance, 8.6% (rate of return needed to grow the trust
    fund in perpetuity): $181.9;
    Palau Trust Fund Balance, 8.1% (rate of return needed to sustain the
    trust fund for 35 years): $157.6.

    Fiscal year: 2023;
    Palau Trust Fund Balance, 9.0% (the compound rate of return Palau trust
    fund earned from inception to March 2008): $210.9;
    Palau Trust Fund Balance, 8.6% (rate of return needed to grow the trust
    fund in perpetuity): $181.9;
    Palau Trust Fund Balance, 8.1% (rate of return needed to sustain the
    trust fund for 35 years): $154.8.

    Fiscal year: 2024;
    Palau Trust Fund Balance, 9.0% (the compound rate of return Palau trust
    fund earned from inception to March 2008): $214.4;
    Palau Trust Fund Balance, 8.6% (rate of return needed to grow the trust
    fund in perpetuity): $181.9;
    Palau Trust Fund Balance, 8.1% (rate of return needed to sustain the
    trust fund for 35 years): $151.7.

    Fiscal year: 2025;
    Palau Trust Fund Balance, 9.0% (the compound rate of return Palau trust
    fund earned from inception to March 2008): $218.3;
    Palau Trust Fund Balance, 8.6% (rate of return needed to grow the trust
    fund in perpetuity): $181.9;
    Palau Trust Fund Balance, 8.1% (rate of return needed to sustain the
    trust fund for 35 years): $148.4.

    Fiscal year: 2026;
    Palau Trust Fund Balance, 9.0% (the compound rate of return Palau trust
    fund earned from inception to March 2008): $222.4;
    Palau Trust Fund Balance, 8.6% (rate of return needed to grow the trust
    fund in perpetuity): $181.9;
    Palau Trust Fund Balance, 8.1% (rate of return needed to sustain the
    trust fund for 35 years): $144.8.

    Fiscal year: 2027;
    Palau Trust Fund Balance, 9.0% (the compound rate of return Palau trust
    fund earned from inception to March 2008): $226.9;
    Palau Trust Fund Balance, 8.6% (rate of return needed to grow the trust
    fund in perpetuity): $181.9;
    Palau Trust Fund Balance, 8.1% (rate of return needed to sustain the
    trust fund for 35 years): $140.9.

    Fiscal year: 2028;
    Palau Trust Fund Balance, 9.0% (the compound rate of return Palau trust
    fund earned from inception to March 2008): $231.9;
    Palau Trust Fund Balance, 8.6% (rate of return needed to grow the trust
    fund in perpetuity): $181.9;
    Palau Trust Fund Balance, 8.1% (rate of return needed to sustain the
    trust fund for 35 years): $136.8.

    Fiscal year: 2029;
    Palau Trust Fund Balance, 9.0% (the compound rate of return Palau trust
    fund earned from inception to March 2008): $237.3;
    Palau Trust Fund Balance, 8.6% (rate of return needed to grow the trust
    fund in perpetuity): $181.9;
    Palau Trust Fund Balance, 8.1% (rate of return needed to sustain the
    trust fund for 35 years): $132.2.

    Fiscal year: 2030;
    Palau Trust Fund Balance, 9.0% (the compound rate of return Palau trust
    fund earned from inception to March 2008): $243.2;
    Palau Trust Fund Balance, 8.6% (rate of return needed to grow the trust
    fund in perpetuity): $181.9;
    Palau Trust Fund Balance, 8.1% (rate of return needed to sustain the
    trust fund for 35 years): $127.4.

    Fiscal year: 2031;
    Palau Trust Fund Balance, 9.0% (the compound rate of return Palau trust
    fund earned from inception to March 2008): $249.6;
    Palau Trust Fund Balance, 8.6% (rate of return needed to grow the trust
    fund in perpetuity): $181.9;
    Palau Trust Fund Balance, 8.1% (rate of return needed to sustain the
    trust fund for 35 years): $122.1.

    Fiscal year: 2032;
    Palau Trust Fund Balance, 9.0% (the compound rate of return Palau trust
    fund earned from inception to March 2008): $256.6;
    Palau Trust Fund Balance, 8.6% (rate of return needed to grow the trust
    fund in perpetuity): $181.9;
    Palau Trust Fund Balance, 8.1% (rate of return needed to sustain the
    trust fund for 35 years): $116.4.

    Fiscal year: 2033;
    Palau Trust Fund Balance, 9.0% (the compound rate of return Palau trust
    fund earned from inception to March 2008): $264.2;
    Palau Trust Fund Balance, 8.6% (rate of return needed to grow the trust
    fund in perpetuity): $181.9;
    Palau Trust Fund Balance, 8.1% (rate of return needed to sustain the
    trust fund for 35 years): $110.3.

    Fiscal year: 2034;
    Palau Trust Fund Balance, 9.0% (the compound rate of return Palau trust
    fund earned from inception to March 2008): $272.5;
    Palau Trust Fund Balance, 8.6% (rate of return needed to grow the trust
    fund in perpetuity): $181.9;
    Palau Trust Fund Balance, 8.1% (rate of return needed to sustain the
    trust fund for 35 years): $103.7.

    Fiscal year: 2035;
    Palau Trust Fund Balance, 9.0% (the compound rate of return Palau trust
    fund earned from inception to March 2008): $281.6;
    Palau Trust Fund Balance, 8.6% (rate of return needed to grow the trust
    fund in perpetuity): $181.9;
    Palau Trust Fund Balance, 8.1% (rate of return needed to sustain the
    trust fund for 35 years): $96.5.

    Fiscal year: 2036;
    Palau Trust Fund Balance, 9.0% (the compound rate of return Palau trust
    fund earned from inception to March 2008): $291.4;
    Palau Trust Fund Balance, 8.6% (rate of return needed to grow the trust
    fund in perpetuity): $181.9;
    Palau Trust Fund Balance, 8.1% (rate of return needed to sustain the
    trust fund for 35 years): $88.8.

    Fiscal year: 2037;
    Palau Trust Fund Balance, 9.0% (the compound rate of return Palau trust
    fund earned from inception to March 2008): $302.2;
    Palau Trust Fund Balance, 8.6% (rate of return needed to grow the trust
    fund in perpetuity): $181.9;
    Palau Trust Fund Balance, 8.1% (rate of return needed to sustain the
    trust fund for 35 years): $80.4.

    Fiscal year: 2038;
    Palau Trust Fund Balance, 9.0% (the compound rate of return Palau trust
    fund earned from inception to March 2008): $313.9;
    Palau Trust Fund Balance, 8.6% (rate of return needed to grow the trust
    fund in perpetuity): $181.9;
    Palau Trust Fund Balance, 8.1% (rate of return needed to sustain the
    trust fund for 35 years): $71.4.

    Fiscal year: 2039;
    Palau Trust Fund Balance, 9.0% (the compound rate of return Palau trust
    fund earned from inception to March 2008): $326.7;
    Palau Trust Fund Balance, 8.6% (rate of return needed to grow the trust
    fund in perpetuity): $181.9;
    Palau Trust Fund Balance, 8.1% (rate of return needed to sustain the
    trust fund for 35 years): $61.8.

    Fiscal year: 2040;
    Palau Trust Fund Balance, 9.0% (the compound rate of return Palau trust
    fund earned from inception to March 2008): $340.6;
    Palau Trust Fund Balance, 8.6% (rate of return needed to grow the trust
    fund in perpetuity): $181.9;
    Palau Trust Fund Balance, 8.1% (rate of return needed to sustain the
    trust fund for 35 years): $51.2.

    Fiscal year: 2041;
    Palau Trust Fund Balance, 9.0% (the compound rate of return Palau trust
    fund earned from inception to March 2008): $355.8;
    Palau Trust Fund Balance, 8.6% (rate of return needed to grow the trust
    fund in perpetuity): $181.9;
    Palau Trust Fund Balance, 8.1% (rate of return needed to sustain the
    trust fund for 35 years): $39.8.

    Fiscal year: 2042;
    Palau Trust Fund Balance, 9.0% (the compound rate of return Palau trust
    fund earned from inception to March 2008): $372.3;
    Palau Trust Fund Balance, 8.6% (rate of return needed to grow the trust
    fund in perpetuity): $181.9;
    Palau Trust Fund Balance, 8.1% (rate of return needed to sustain the
    trust fund for 35 years): $27.5.

    Fiscal year:
    Palau Trust Fund Balance, 9.0% (the compound rate of return Palau trust
    fund earned from inception to March 2008): $390.4;
    Palau Trust Fund Balance, 8.6% (rate of return needed to grow the trust
    fund in perpetuity): $181.9;
    Palau Trust Fund Balance, 8.1% (rate of return needed to sustain the
    trust fund for 35 years): $14.3.

    Fiscal year:
    Palau Trust Fund Balance, 9.0% (the compound rate of return Palau trust
    fund earned from inception to March 2008): $410.0;
    Palau Trust Fund Balance, 8.6% (rate of return needed to grow the trust
    fund in perpetuity): $181.9;
    Palau Trust Fund Balance, 8.1% (rate of return needed to sustain the
    trust fund for 35 years): $0.000421.

    Source: GAO analysis.

    Note: Years shown are fiscal years (Oct. 1-Sept. 30). All return rates
    are net of fees and commissions.

    [End of figure]

    However, market volatility adds uncertainty regarding the availability
    of the trust fund withdrawals. Despite its historical compounded annual
    return rate of 9 percent as of March 2008, the trust fund's annual
    investment returns have ranged from 24 percent in 1998 to negative 12
    percent in 2002. Future returns to the Palau trust fund portfolio are
    uncertain. Even if the trust fund earns a favorable long-run return
    which could allow the fund to grow in perpetuity without market
    volatility,[Footnote 56] a few consecutive years of poor stock market
    performance could lead to the depletion of the trust fund. Figure 7
    illustrates results from our analysis with the assumption that future
    returns are drawn from distributions based on historical 1970-2007
    returns of the asset classes in which Palau's trust fund is invested.
    Our analysis shows that the trust fund will be able to disburse $15
    million per year through 2016 but is increasingly likely to be depleted
    after 2016. For example, by 2030, 20 years after the annual $15 million
    disbursement begins, the probability of the trust fund depletion is
    close to 26 percent; by 2044, 35 years after the $15 million
    disbursement begins, the probability reaches approximately 46 percent.
    Figure 7 illustrates results from our analysis based on the historical
    returns for 1970-2007 of the asset classes held in the Palau trust
    fund. (For a detailed discussion of our methodology and results, see
    app. IV.)

    Figure 7: Probability That Palau Trust Fund Will Be Depleted Given
    Market Volatility, 2010-2044:

    [See PDF for image]

    This figure is a line graph depicting the following data:

    Fiscal year: 2010;
    Percentage: 0.

    Fiscal year: 2011;
    Percentage: 0.

    Fiscal year: 2012;
    Percentage: 0.

    Fiscal year: 2014;
    Percentage: 0.

    Fiscal year: 2015;
    Percentage: 0.

    Fiscal year: 2016;
    Percentage: 0.

    Fiscal year: 2017;
    Percentage: 0.03%.

    Fiscal year: 2018;
    Percentage: 0.16%.

    Fiscal year: 2019;
    Percentage: 0.52%

    Fiscal year: 2020;
    Percentage: 1.37%.

    Fiscal year: 2021;
    Percentage: 2.91%.

    Fiscal year: 2022;
    Percentage: 4.94%.

    Fiscal year: 2023;
    Percentage: 7.12%.

    Fiscal year: 2024;
    Percentage: 9.73.

    Fiscal year: 2025;
    Percentage: 12.37%.

    Fiscal year: 2026;
    Percentage: 15.34%.

    Fiscal year: 2027;
    Percentage: 18.13%.

    Fiscal year: 2028;
    Percentage: 20.74%.

    Fiscal year: 2029;
    Percentage: 23.66%.

    Fiscal year: 2030;
    Percentage: 25.97%.

    Fiscal year: 2031;
    Percentage: 28.38%.

    Fiscal year: 2032;
    Percentage: 30.58%.

    Fiscal year: 2033;
    Percentage: 32.45%.

    Fiscal year: 2034;
    Percentage: 34.08%.

    Fiscal year: 2035;
    Percentage: 35.86%.

    Fiscal year: 2036;
    Percentage: 37.54%.

    Fiscal year: 2037;
    Percentage: 38.85%.

    Fiscal year: 2038;
    Percentage: 39.96%.

    Fiscal year: 2039;
    Percentage: 41.19%.

    Fiscal year: 2040;
    Percentage: 42.33%.

    Fiscal year: 2041;
    Percentage: 43.3%.

    Fiscal year: 2042;
    Percentage: 44.26%.

    Fiscal year: 2043;
    Percentage: 45.18%.

    Fiscal year: 2044;
    Percentage: 46%.

    Source: GAO analysis.

    Notes:

    All years cited are fiscal years (Oct. 1-Sept. 30).

    This chart depicts results from 10,000 trial runs. For each run, the
    returns of each of the asset classes are randomly drawn from a
    distribution based on the historical returns (1970-2007). The account
    balances and the amount of disbursements from the trust fund are then
    calculated based on the returns. The probability of not being able to
    disburse $15 million is then generated from a distribution of 10,000
    disbursements each year.

    [End of figure]

    In addition, inflation will diminish the value of the annual trust fund
    withdrawals: because the withdrawals are not adjusted for inflation,
    [Footnote 57] they will lose real value over time. We estimate that by
    2044-the last year of planned trust fund assistance-the value of the
    annual withdrawal will have decreased by about half compared with its
    value in 2010.[Footnote 58]

    Prospects for Economic Self-Sufficiency Depend on Fiscal Reform:

    Palau's prospects for economic self-sufficiency depend in part on
    fiscal reform to reduce Palau's long-term dependence on trust fund
    withdrawals. Government officials and IMF experts have defined fiscal
    sustainability for Palau after 2009 as having sufficient domestic
    revenues, such as tax and fee income, to pay for operating
    expenditures, such as those for wages, goods, and services.[Footnote
    59] Continued donor assistance could be used to pay for capital
    expenditures. In 2000-2006, domestic revenues provided an average of 50
    percent of national government revenue, while operating expenditures
    accounted for an average of 79 percent of national government spending.
    Beginning in 2010, Palau will have access to the $15 million annual
    trust fund withdrawals to finance the gap between its revenues and
    expenditures. However, Palau's long-term fiscal sustainability relies
    on reduced dependence on the full trust fund withdrawal, given (a) the
    uncertainty of continued donor assistance for capital spending, (b) the
    declining real value of the annual withdrawal, and (c) the planned
    exhaustion of the trust fund in 2044, with risks for its earlier
    exhaustion due to market volatility.[Footnote 60] According to economic
    experts, Palau officials, and the country's economic plans,
    implementation of tax and expenditure reforms will be needed to close
    the gap between Palau's revenues and expenditures, although full
    implementation of such reforms is expected to require 10 to 15 years.
    [Footnote 61]

    Tax revenues. In 2006, tax revenue provided about $30 million and was
    equivalent to 19 percent of GDP, a level broadly comparable to that of
    other Pacific island nations. However, IMF and Asian Development Bank
    (ADB) experts describe Palau's tax system as inefficient because of,
    among other problems, weak tax administration and ineffective tax
    policy:

    * Tax administration. Tax compliance in Palau is low, and the
    government rarely collects assessed penalties and interest or exercises
    its authority to suspend or revoke business licenses. The IMF and ADB
    estimate that fewer than 50 percent of active taxpayers are fully
    compliant. For example, in a 2004-2005 review, the Palau Office of the
    Public Auditor found that Palau lost more than $7.5 million in
    uncollected taxes and penalties for just 15 businesses in 1998-2005.
    [Footnote 62] Also, although the government conducts tax audits, it
    rarely closes noncompliant businesses and usually waives penalties and
    interest. For example, in 2007, the government settled with Palau
    Marine Industries Corporation to pay $1.25 million on a court-awarded
    total obligation of over $5.7 million for unpaid taxes from 1999
    through 2004.[Footnote 63] The IMF and ADB are working with Palau on a
    tax modernization project to improve Palau's tax administration and
    possibly establish a Large Taxpayer Unit to focus on Palau's largest
    taxpayers.

    * Tax policy. Experts and officials stated that Palau's tax policy
    allows numerous and complicated exemptions, and the current system does
    not tax nonwage income, such as that from profits, investment, or
    property. Additionally, Palau taxes businesses on gross, rather than
    net, earnings. To address these problems, Palau has consulted with the
    IMF and ADB since the 1990s and began devising tax reform legislation
    in 1998. However, Palau authorities indicated an intention to focus
    initially on short-term measures, primarily addressing rates and
    exemptions, and pursue structural reform over the long term. Palau's
    2007 Tax Reform Task Force suggested 19 short-term measures that it
    estimated could provide an additional $31 million in revenues. To date,
    2 of the 19 measures--increasing the hotel room tax rate and fish
    export tax rate--have been implemented.

    Expenditures. Economic experts and government officials also suggest
    that Palau could lower its operating expenditures, at around $67
    million in 2006, by reducing the public sector wage bill:

    * Public sector wage bill. Although Palau has slightly reduced nonwage
    operating expenditures since 2000, it has been less successful in
    reducing the wage bill. From 2000-2006, Palau's national government
    wage bill grew from 46 percent to 50 percent of its operating
    expenditures, with wage levels nearly twice those in the private
    sector. According to government officials, Palau instituted a freeze on
    public sector employment in 2001 that has not been observed, and recent
    public sector reclassification efforts will result in a further
    increase in wage expenditures.[Footnote 64]

    Palau's Prospects for Economic Self-sufficiency Depend on Improved
    Business Environment for Private Sector Growth:

    Palau's prospects for economic self-sufficiency depend in part on the
    growth of its economy through private sector expansion, which will
    require an improved business environment. Palau's strategy for
    expanding its private sector focuses primarily on pursuing
    environmentally sustainable growth by promoting high-end tourism and
    capitalizing on growth opportunities from the new compact road.
    [Footnote 65] Officials, experts, and private sector representatives
    view the tourism sector as offering the most potential for growth. For
    example, the IMF estimates that every 2 percent increase in tourist
    arrivals creates a 1 percent increase in tourism-related employment and
    that more than a third of foreign direct investment occurs in this
    sector. Current Palau tourism strategies aim to capitalize on
    opportunities for high-end tourists[Footnote 66] from Asia and from
    U.S. military bases on Guam. The marine and agricultural industries
    together provide less than 5 percent of GDP; however, Palau is pursuing
    opportunities in aquaculture and considering whether foreign fishing
    license fees could be raised. In all cases, private sector development
    is dependent on sustained exploitation of Palau's fragile environmental
    resources.[Footnote 67]

    However, according to Palau government officials, economic experts, and
    private sector representatives, problems related to Palau's foreign
    investment policies, financial systems, land ownership system, labor
    market, and commercial conditions create a costly business environment
    that discourages private sector growth:

    * Foreign investment policies. Palau imposes stringent requirements on
    foreign investment, restricting foreign investment in certain
    activities and requiring all applications to be approved by its Foreign
    Investment Board. According to officials from the board and Palau's
    foreign investment regulations, foreign investment in allowed
    activities must meet a minimum of $500,000 or have a minimum 20 percent
    Palauan ownership. Private sector representatives indicated that the
    Foreign Investment Board has significant discretion and applies the law
    inconsistently. Both officials and private sector representatives
    reported that burdensome requirements have encouraged the establishment
    of front businesses, where foreign investors operate illegally through
    a Palauan partner.

    * Financial systems. Palau's financial markets do not effectively
    finance investment but instead supply large amounts of consumer credit.
    Moreover, Palau's foreign banks are unable to accept land as
    collateral, and financial regulations remain weak.[Footnote 68]
    According to the IMF, Palau's Financial Institutions Act allows for
    insufficient bank liquidity and does not sufficiently empower the
    government to supervise bank compliance. The recent failure of Pacific
    Savings Bank illustrates the impact of weak regulation.[Footnote 69] In
    commenting on this report, officials from Palau's Financial
    Institutions Commission said that recent legislative amendments will
    allow the Commission to strengthen its supervision of Palau's banking
    industry.

    * Land ownership system. Palau's system of land ownership prevents the
    effective use of land for development. Much of Palau's land is family
    owned and not officially registered. Palau's Land Court is working to
    ensure that all lands are registered. However, Bureau of Lands and
    Surveys officials were unable to locate reliable statistics on
    registrations and suggested that fewer than 3,000 of 17,000 existing
    parcels had been referred to the Court. Separately, Land Court
    officials suggested that about 4,100 parcels had been registered.

    * Labor market. Private sector representatives indicated a lack of
    available skilled labor in Palau, and Palau government officials
    expressed concern about illegal importation of unskilled foreign
    workers. ADB reports emphasize that current labor laws discriminate
    against the import of skilled labor and that minimum wage laws for
    Palauan workers encourage importation of unskilled foreign labor
    through unlicensed recruiters. Palau's Department of Labor receives
    many grievances from the Philippines Embassy about treatment of
    unskilled workers, who are often paid less than $150 per month and lack
    health benefits.

    * Commercial conditions. Experts describe Palau's commercial legal
    system as outdated and lacking laws for bankruptcy, sales, and consumer
    privacy protection. Additionally, private sector representatives
    complained that the government often delays payment of vendors for
    several years.[Footnote 70] Officials and private sector
    representatives also emphasized that, owing to the small size of the
    population, government officials often engage in private sector
    activities that create commercial conflicts of interest. For example,
    according to these officials and representatives, government officials
    with interests in construction companies or banking often are unwilling
    to enforce environmental or financial regulations.

    Conclusions:

    In 2009, the governments of the United States and Palau will formally
    review the terms of the compact and its related agreements. Compact and
    other U.S. assistance has contributed to several areas important to
    Palau's self-sufficiency and economic advancement. For example, Palau
    used U.S. assistance to support governmental operations, maintain
    needed services, develop infrastructure, and improve public health and
    education. Although compact direct assistance will expire in 2009, the
    provision of federal services--postal, weather, and aviation--may
    continue if the federal programs and services agreement is renewed or
    extended. Moreover, it is likely that some discretionary federal
    programs will continue, although the level of federal program funding
    depends on Palau's continued eligibility, which may require affirmative
    action by Congress in some cases. Interior's OIA will continue to be
    the cognizant agency for Palau for the remaining compact direct
    assistance and to review Palau's single audits as long as U.S. federal
    program funds are expended in Palau. Palau has made progress in
    financial accountability, improving the timeliness of single audit
    report submissions and the reliability of its financial statements.
    However, Palau's single audit reports show persistent weaknesses in
    Palau's internal controls over financial reporting and compliance with
    federal award requirements. At the same time, Palau has limited
    capacity to address these weaknesses in a timely manner. Unless Palau
    strengthens its financial accounting resources and expertise, its
    ability to sustain its recent progress in financial accountability and
    to operate a major federal program according to applicable requirements
    is at risk.

    Recommendation for Executive Action:

    To strengthen Palau's ability to provide accountability and meet
    applicable requirements for federal assistance, we recommend that the
    Secretary of the Interior direct the Office of Insular Affairs to (1)
    formally consult with the government of Palau regarding Palau's
    financial management challenges and (2) target future technical
    assistance toward building Palau's financial management capacity.

    Agency Comments and Our Evaluation:

    We provided a draft of this report to the Secretary of the Interior,
    the Secretary of State, and the government of Palau. The Secretary of
    the Interior and the government of Palau provided comments, which we
    have included in appendixes VIII and IX, respectively. The Department
    of State did not comment on the report. In addition, we received
    technical comments from USDA, Education, and Homeland Security, as well
    as the FAA, NWS, USPS, and the USACE, which we have incorporated as
    appropriate.

    The Department of the Interior agreed with our report's findings and
    said that the report was useful to the department as it prepared for
    the compact review between the United States and Palau. Interior
    concurred with our recommendation, noting that it had begun preliminary
    discussions with its training partner, the U.S. Department of
    Agriculture Graduate School, to implement a program of leadership and
    succession planning for key positions in the island governments, and
    that it would address Palau's needs specifically as part of the compact
    review. The government of Palau also agreed with our findings and noted
    that Interior's OIA had provided support to Palau's on-going efforts to
    improve its financial management capacity through the Pacific Islands
    Training Initiative and the Financial Management Improvement Program.
    In addition, the government of Palau supported our recommendation that
    OIA continue to assist Palau in building financial management capacity.
    Palau added that it intended to establish an ongoing institutional
    strengthening program focused on human resource development and
    improved retention of key personnel to ensure the sustainability of its
    financial management improvements.

    We are sending this report to the Secretary of the Interior, the
    Secretary of State, the government of Palau, and interested
    congressional committees. In addition, the report will be available at
    no charge on GAO's Web site, at [hyperlink, http://www.gao.gov].

    If you or your staffs have 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 X.

    Signed by:

    David Gootnick:
    Director, International Affairs and Trade:

    [End of section]

    Appendix I: Objectives, Scope, and Methodology:

    This report examines (1) the provision of compact and other U.S.
    assistance to Palau from 1995-2009,[Footnote 71] (2) Palau's and U.S.
    agencies' efforts to provide accountability over Palau's use of federal
    funds in 1995-2006, and (3) Palau's prospects for achieving economic
    self-sufficiency.

    To address our objectives, we reviewed the Compact of Free Association
    between Palau and the United States and subsidiary agreements related
    to the compact, Palau's compact annual reports for 1995-2006, Palau's
    single audit reports for 1995-2006,[Footnote 72] Palau government
    budgets, economic studies, and documentation for the compact road
    project. We interviewed agency officials at the Department of the
    Interior's (Interior) Office of Insular Affairs (OIA) and Office of the
    Inspector General (OIG), and the Departments of State (State),
    Agriculture (USDA), Defense (DOD), Education (Education), Health and
    Human Services (HHS), Homeland Security, Labor, and Transportation
    (DOT). We also interviewed officials from the U.S. Army Corps of
    Engineers (USACE), the Federal Aviation Administration (FAA), the U.S.
    Postal Service (USPS), and the National Weather Service (NWS), as well
    as economic experts from the International Monetary Fund (IMF) and the
    Asian Development Bank (ADB). We traveled to Palau where we conducted
    site visits and interviewed government officials from a range of
    ministries, including the ministries of Finance, Health, Education, and
    Resources and Development, and the Office of the Public Auditor. We
    also interviewed Palau's external auditor and met with representatives
    of the private sector and nongovernmental organizations in Palau. We
    inspected the compact road and viewed infrastructure improvements made
    to Palau's airport that were funded by FAA's Airport Improvement
    Program.

    To identify compact and other types of U.S. assistance to Palau in 1995-
    2009, we reviewed the compact and its related agreements; Palau's
    compact annual reports; Palau government budgets; and single audit
    reports for the Palau national government, the Palau Community College,
    and the Palau Community Action Agency. We used OIA budget
    justifications to estimate compact direct assistance from 1995 to 2009,
    as well as the estimated U.S. cost for the compact road. We used
    information provided by agency officials at FAA, USPS, and NWS to
    estimate the cost of compact federal services. Because FAA's cost
    estimates included the costs of providing services to six airports in
    Micronesia, we divided this cost by six to calculate a general estimate
    of the costs associated with Palau's one airport. USPS provided us with
    cost estimates from 1995 through 2009. NWS provided us with cost
    estimates from 2004 through 2007; we averaged these 4 years of data to
    estimate the annual costs in 1995-2003 and 2008-2009. We used single
    audit information from the three primary grant recipients--the Palau
    national government, the Palau Community College, and the Palau
    Community Action Agency--to determine those entities' actual grant
    expenditures. We estimated the Palau national government's grant
    expenditures for 2007-2009 using its budgetary estimates for those
    years and we projected grant expenditures for the other two entities
    based on their 2006 actual expenditures, after adjusting for inflation.
    We used information provided by DOD officials to estimate the cost to
    the department of providing the Civic Action Team (CAT) to Palau in
    1995-2009. To include personnel as well as operating expenses, we
    adjusted the CAT's 2007 personnel cost for inflation to provide a broad
    estimate for 1995-2009.

    To assess Palau's and U.S. agencies' efforts to provide accountability
    over Palau's use of federal funds in 1995-2006, we reviewed the compact
    and its related agreements to identify specific monitoring and
    accountability responsibilities and assessed the extent to which the
    Palau and U.S. governments conducted those responsibilities. We met
    with State and OIA officials to learn about their monitoring and
    oversight activities. We interviewed Palau government officials to
    identify Palau's accountability measures over federal grant awards. We
    also interviewed Palau's external auditor to discuss Palau's single
    audit results, accountability mechanisms, and accountability
    challenges. We reviewed the Palau national government single audit
    reports for 1995-2006 as well as audit reports from Palau's Office of
    the Public Auditor. We determined the timeliness of submission of the
    single audit reports using the Federal Audit Clearinghouse's (FAC)
    "Form Date," which is the most recent date that the required SF-FAC
    data collection form was received by the FAC.[Footnote 73] We noted
    that the form date is updated if revised SF-FACs for that same fiscal
    year are subsequently filed. Our review of the contents of the single
    audit reports' contents identified the auditors' opinions on the
    financial statements and on Palau's compliance with federal grant
    requirements, matters cited by the auditors in their qualified
    opinions, the numbers of material weaknesses and reportable conditions
    reported by the auditors, and the status of corrective actions. We did
    not independently assess the quality of the audits or the reliability
    of the audit-finding information. We analyzed the audit findings to
    determine whether they had recurred in successive single audits and
    were still occurring in the most recent audits, and we categorized the
    auditors' opinions on the financial statements and Palau's compliance
    with major federal programs. To determine oversight activities, we
    reviewed Interior's OIG memorandums issued in December 2005 and January
    2006 on Palau, as well as the OIG's desk review of Palau's single audit
    reports for 2002-2006.

    To analyze Palau's prospects for achieving economic self-sufficiency,
    we used the data we had developed concerning compact and other U.S.
    assistance to Palau, as well as Palau's national government budgetary
    information, to describe the role of U.S. financial assistance to the
    government of Palau. We reviewed Palau's compact annual reports,
    economic development plans, and data for sector employment and
    production levels. We also reviewed studies and interviewed officials
    from the U.S. and Palau governments, Palau's private sector, the IMF,
    and the ADB. As part of this analysis, we projected Palau's trust fund
    balance and likely disbursement. To do so, we built a simulation model
    with the following inputs: (1) the trust fund's balance at the
    beginning of the projection, (2) disbursement and inflation adjustment,
    (3) the trust fund balance projection equation, and (4) distribution of
    returns for the Monte Carlo simulation. The trust fund balance as of
    March 2008 is the beginning balance for the projection. We followed the
    disbursement schedule outlined in the compact and the trust fund
    agreement. We ran the Monte Carlo simulation to analyze the effect of
    market volatility on the trust fund balance and disbursement. We base
    our projection on historical returns and volatility; however, the
    actual return on the trust fund may be different.

    To determine the challenges encountered in the planning, design, and
    construction of the compact road, and the challenges that remain for
    the maintenance of the compact road, we interviewed officials from OIA,
    State, USACE, and the Palau government; nongovernmental individuals,
    including the author of the maintenance plan for the compact road; and
    the representative of a contracting firm in Palau. In Palau, we
    inspected the entire compact road to identify any obvious problems with
    the road. We also visited other roads maintained by Palau and reviewed
    the equipment Palau uses to maintain roads. In addition, we reviewed
    reports, equipment inventories, contract documents, budgets, plans,
    manuals, guidance, Internet Web sites, court decisions, and laws
    relevant to the construction and maintenance of the compact road. We
    did not interview Daewoo Engineering and Construction Co., Ltd., the
    contractor for the compact road, due to ongoing litigation between the
    contractor and the United States. (See app. V for more information
    about the compact road.)

    We conducted this performance audit from October 2007 to June 2008 in
    accordance with generally accepted government auditing standards. Those
    standards require that we plan and perform the audit to obtain
    sufficient, appropriate evidence to provide a reasonable basis for our
    findings and conclusions based on our audit objectives. We believe that
    the evidence obtained provides a reasonable basis for our findings and
    conclusions based on our audit objectives.

    [End of section]

    Appendix II: Relevancy of Amendments Made to FSM and RMI Compacts for
    Palau Compact Review:

    In 1986, the United States entered into a Compact of Free Association
    with the Federated States of Micronesia (FSM) and the Republic of the
    Marshall Islands (RMI).[Footnote 74] The three countries renegotiated
    the compact in 2003 to provide an additional 20 years of economic
    assistance and to address defense and immigration issues.[Footnote 75]
    The aims of the amended FSM and RMI compacts were to (1) continue
    economic assistance to the FSM and RMI while improving accountability
    and effectiveness; (2) continue the defense relationship between the
    United States and the FSM and the RMI including a 50-year lease
    extension of U.S. military access to Kwajalein Atoll in the RMI until
    2066, with an option to extend for an additional 20 years to 2086; and
    (3) strengthen immigration provisions.[Footnote 76] Some of these
    amendments may be relevant for the Palau compact review in 2009, but
    others may be less relevant due to the differences between Palau's
    compact and the FSM's and the RMI's compacts and Palau's performance
    under its compact.

    FSM's and RMI's Renegotiated Compacts Continued Economic Assistance
    while Increasing Accountability Requirements:

    The FSM's and the RMI's amended compacts authorized additional economic
    assistance while increasing the accountability requirements for the two
    countries and the United States. The new authorized funding took the
    form of 20 years of annual grants, contributions to a newly established
    trust fund for each country, and an extension of federal services.
    [Footnote 77] The amended compacts established additional
    accountability measures over the annual grant funds. For example, new
    authorized funding was targeted to priority areas such as health,
    education, the environment, and public infrastructure. Joint economic
    management committees were established for each country to more closely
    monitor and evaluate the FSM's and the RMI's progress, and annual
    reporting requirements were expanded. The United States and the FSM and
    the RMI jointly manage the two countries' trust funds. The amended
    compacts grant the United States the authority to withhold payments if
    either the FSM or the RMI fail to comply with grant terms and
    conditions or if they do not cooperate in U.S. investigations regarding
    use of compact funds.

    Based on our interviews with U.S. government officials concerning
    Palau's compact review, it is unclear whether a new economic assistance
    package will be offered to Palau and, if it were offered, whether
    additional accountability measures would be sought. Moreover, the
    establishment of a trust fund for the FSM and the RMI is not relevant
    for Palau since Palau's initial compact included a trust fund. One
    issue that is relevant for Palau is the continuation of compact federal
    services--postal, weather, and aviation--which the United States
    provides to Palau. In our discussions with officials from USPS, NWS,
    and FAA, we were told that each agency would like to continue offering
    these services to Palau, although they may seek some minor changes to
    the services provided.

    Defense Issues in the Amended FSM and RMI Compacts:

    The most significant defense-related change in the amended FSM and RMI
    compacts was the extension of U.S. military access to Kwajalein Atoll
    in the RMI. A few other expiring defense provisions were extended
    indefinitely in the amended compacts, such as the U.S. "defense veto"
    and the ability of FSM and RMI citizens to volunteer to serve in the
    U.S. military. In the amended FSM and RMI compacts, CATs were
    eliminated; instead, both countries were given access to humanitarian
    assistance programs that would emphasize health, education, and
    infrastructure projects that DOD would carry out. DOD officials told us
    that defense provisions in title three of the Palau compact do not
    expire until 2044. The provision of the CATs to Palau, which is
    provided for in the Palau compact's implementing legislation, continues
    indefinitely, although DOD officials told us the CAT program in Palau
    will continue until 2044.

    Strengthened Immigration Provisions in the Amended FSM and RMI Compacts:

    Although the immigration provisions in the original FSM and RMI compact
    were not expiring, State targeted them as requiring change during the
    compact renegotiation process. The major change in the amended compacts
    is that FSM and RMI citizens were required to present a passport before
    being allowed to enter the United States, which the original compact
    did not require. Other changes to the immigration provisions tightened
    rules for the entry of naturalized citizens from the FSM and the RMI,
    amended provisions for adopted children, and amended conditions on
    admission for compact nonimmigrants.

    State officials said that it would be desirable for immigration
    provisions of Palau's compact to be in line with the FSM and RMI
    compacts. This is one issue the U.S. government will look at in
    preparation for the 2009 compact review. Department of Homeland
    Security officials said that they would like citizens of Palau to be
    required to present passports for admission into the United States to
    aid officers in their inspection of Palauans' identity documents. Data
    requested from Homeland Security showed that some citizens of Palau
    enter the United States using identity documents other than a passport.
    However, the port director at the airport in Guam, the port of entry
    through which many Palauans enter the United States, did not cite
    specific concerns over this lack of a passport requirement. He said
    that the Palauans' ability to enter without a passport may cause some
    confusion at other ports where officers may be less familiar with
    Palauan citizens' immigration privileges. In commenting on this report,
    officials from U.S. Customs and Border Protection stated that a
    passport requirement for citizens of Palau entering the United States
    would eliminate confusion at ports that typically do not see these
    individuals, and that it would be in alignment with the Western
    Hemisphere Travel Initiative requirements already in place. In
    addition, they stated that having a passport would facilitate Palauan
    citizens in obtaining a Social Security card, driver's license, or
    other government-issued identification cards that generally require a
    passport as a supporting document.

    Supplemental Education Grant in the Amended FSM and RMI Compacts'
    Implementing Legislation:

    In addition to receiving compact grants, the FSM and the RMI are
    eligible for a Supplemental Education Grant. The amended compacts'
    implementing legislation authorized appropriations to the U.S.
    Secretary of Education on an annual basis beginning in 2005, to
    supplement the education grants under the amended compacts. The
    supplement grant is awarded in place of grant assistance formerly
    awarded to the countries under several U.S. education, health, and
    labor programs.

    [End of section]

    Appendix III: Economic Information for Palau:

    This appendix provides fiscal and economic information for Palau's
    national government. Specifically, table 6 provides data on Palau's
    actual revenue and expenditures for 2000 to 2006 and estimated values
    for these items in 2009. In addition to its annual revenues, Palau has
    access to financing through net changes in its government assets. One
    key source of financing for Palau is interest earned on the compact-
    provided trust fund, as well as the permitted annual withdrawals from
    the fund. Given that this trust fund was designed to provide Palau with
    financing only until 2044, in addition to the market volatility
    associated with investment earnings, we have excluded net financing
    from the revenues illustrated in table 6. Instead, both net
    investments--defined as the net increase in the fair value of
    investments minus investment management fees--and annual trust fund
    withdrawals are provided as memo items in the table. For further
    information on 2006 fiscal and economic data for Palau, in comparison
    to the RMI and the FSM, see table 7.

    Table 6: Palau's National Government Finances, 2000-2006 (Dollars in
    thousands):

    Total revenue:
    2000: $57,263;
    2001: $58,925;
    2002: $59,432;
    2003: $65,551;
    2004: $68,720;
    2005: $73,717;
    2006: $83,324;
    Potential 2009[B]: $86,606.

    Domestic revenue[A]:
    2000: $29,993;
    2001: $30,943;
    2002: $30,648;
    2003: $31,343;
    2004: $32,667;
    2005: $38,928;
    2006: $38,975;
    Potential 2009[B]: $43,632.

    Domestic revenue[A], Tax income:
    2000: $24,398;
    2001: $25,648;
    2002: $24,097;
    2003: $24,723;
    2004: $26,130;
    2005: $30,085;
    2006: $29,376;
    Potential 2009[B]: $35,599.

    U.S. assistance:
    2000: $20,908;
    2001: $21,091;
    2002: $21,481;
    2003: $21,962;
    2004: $26,320;
    2005: $21,225;
    2006: $31,525;
    Potential 2009[B]: $25,185.

    U.S. assistance, Compact direct assistance:
    2000: $13,642;
    2001: $13,785;
    2002: $13,928;
    2003: $13,928;
    2004: $14,071;
    2005: $10,471;
    2006: $12,717;
    Potential 2009[B]: $13,271.

    U.S. assistance, Discretionary federal programs[C]:
    2000: $7,266;
    2001: $7,306;
    2002: $7,553;
    2003: $8,034;
    2004: $12,249;
    2005: $10,754;
    2006: $18,808;
    Potential 2009[B]: $11,914.

    Other donor assistance:
    2000: $6,362;
    2001: $6,891;
    2002: $7,303;
    2003: $12,246;
    2004: $9,733;
    2005: $13,564;
    2006: $12,824;
    Potential 2009[B]: $17,789.

    Total expenditure:
    2000: $77,609;
    2001: $77,432;
    2002: $80,867;
    2003: $76,840;
    2004: $83,057;
    2005: $78,086;
    2006: $89,342;
    Potential 2009[B]: $92,655.

    Operating expenditure[D]:
    2000: $65,108;
    2001: $62,071;
    2002: $59,829;
    2003: $61,495;
    2004: $63,030;
    2005: $64,450;
    2006: $66,614;
    Potential 2009[B]:$67,616.

    Operating expenditure[D], Wages and salaries:
    2000: $29,990;
    2001: $30,573;
    2002: $31,405;
    2003: $32,759;
    2004: $31,910;
    2005: $32,309;
    2006: $33,242;
    Potential 2009[B]: $34,580.

    Capital expenditures:
    2000: $12,501;
    2001: $15,361;
    2002: $21,038;
    2003: $15,345;
    2004: $20,027;
    2005: $13,636;
    2006: $22,728;
    Potential 2009[B]: $25,039.

    Memo items, Net investments[E]:
    2000: $16,863;
    2001: -$14,405;
    2002: -$3,439;
    2003: $18,191;
    2004: $10,748;
    2005: $18,273;
    2006: $9,866;
    Potential 2009[B]: [Empty].

    Memo items, U.S. trust fund withdrawal:
    2000: $0;
    2001: $0;
    2002: $5,000;
    2003: $5,000;
    2004: $5,000;
    2005: $5,000;
    2006: $5,000;
    Potential 2009[B]: $5,000.

    Memo items, Gross domestic product (GDP);
    2000: $118,269;
    2001: $123,458;
    2002: $120,755;
    2003: $121,909;
    2004: $130,852;
    2005: $141,889;
    2006: $154,430;
    Potential 2009[B]: [Empty].

    Memo items, U.S. cost of compact federal services received[F]:
    2000: $1,742;
    2001: $1,742;
    2002: $1,745;
    2003: $1,749;
    2004: $1,584;
    2005: $1,623;
    2006: $1,678;
    Potential 2009[B]: $1,595.

    Memo items, Population (actual number);
    2000: 18,766;
    2001: 19,092;
    2002: 19,409;
    2003: 19,717;
    2004: 20,016;
    2005: 20,303;
    2006: 20,579;
    Potential 2009[B]: [Empty].

    Percentage of GDP (%), Total revenues:
    2000: 48%;
    2001: 48%;
    2002: 49%;
    2003: 54%;
    2004: 53%;
    2005: 52%;
    2006: 54%;
    Potential 2009[B]: [Empty].

    Percentage of GDP (%), Domestic revenue:
    2000: 25%;
    2001: 25%;
    2002: 25%;
    2003: 26%;
    2004: 25%;
    2005: 2%7;
    2006: 25%;
    Potential 2009[B]: [Empty].

    Percentage of GDP (%), Domestic revenue: Tax income:
    2000: 21%;
    2001: 21%;
    2002: 20%;
    2003: 20%;
    2004: 20%;
    2005: 21%;
    2006: 19%;
    Potential 2009[B]: [Empty].

    Percentage of GDP (%), U.S. assistance:
    2000: 18%;
    2001: 17%;
    2002: 18%;
    2003: 18%;
    2004: 20%;
    2005: 15%;
    2006: 20%;
    Potential 2009[B]: [Empty].

    Percentage of GDP (%), U.S. assistance: Compact direct assistance:
    2000: 12%;
    2001: 11%;
    2002: 12%;
    2003: 11%;
    2004: 11%;
    2005: 7%;
    2006: 8%;
    Potential 2009[B]: [Empty].

    Percentage of GDP (%), U.S. assistance: Discretionary federal programs:
    2000: 6%;
    2001: 6%;
    2002: 6%;
    2003: 7%;
    2004: 9%;
    2005: 8%;
    2006: 12%;
    Potential 2009[B]: [Empty].

    Percentage of GDP (%), Other donor assistance:
    2000: 5%;
    2001: 6%;
    2002: 6%;
    2003: 10%;
    2004: 7%;
    2005: 10%;
    2006: 8%;
    Potential 2009[B]: [Empty].

    Total expenditures:
    2000: 66%;
    2001: 63%;
    2002: 67%;
    2003: 63%;
    2004: 63%;
    2005: 55%;
    2006: 58%;
    Potential 2009[B]: [Empty].

    Operating expenditure:
    2000: 55%;
    2001: 50%;
    2002: 50%;
    2003: 50%;
    2004: 48%;
    2005: 45%;
    2006: 43%;
    Potential 2009[B]: [Empty].

    Operating expenditure: Wages and salaries:
    2000: 25%;
    2001: 25%;
    2002: 26%;
    2003: 27%;
    2004: 24%;
    2005: 23%;
    2006: 22%;
    Potential 2009[B]: [Empty].

    Capital expenditures:
    2000: 11%;
    2001: 12%;
    2002: 17%;
    2003: 13%;
    2004: 15%;
    2005: 10%;
    2006: 15%;
    Potential 2009[B]: [Empty].

    Memo items: Net investments:
    2000: 14%;
    2001: -12%;
    2002: -3%;
    2003: 15%;
    2004: 8%;
    2005: 13%;
    2006: 6%;
    Potential 2009[B]: [Empty].

    Memo items: U.S. trust fund withdrawal:
    2000: 0%;
    2001: 0%;
    2002: 4%;
    2003: 4%;
    2004: 4%;
    2005: 4%;
    2006: 3%;
    Potential 2009[B]: [Empty].

    Memo items: U.S. cost of compact federal services received:
    2000: 1%;
    2001: 1%;
    2002: 1%;
    2003: 1%;
    2004: 1%;
    2005: 1%;
    2006: 1%;
    Potential 2009[B]: [Empty].

    Source: GAO estimates of Palau's single audit data.

    Note: All data are for Palau's national government and exclude
    component units. Except for the U.S. cost of compact federal services
    received, population, and GDP, all data for 2000-2006 are based on
    Palau single audits. Years cited are fiscal years (Oct. 1-Sept. 30).

    [A] Domestic revenue includes taxes, fees and charges, licenses and
    permits, and other direct revenue, and excludes the net change in the
    fair value of investments.

    [B] To estimate potential 2009 domestic revenue and total expenditure,
    we reviewed Palau budgets for 2007 and 2008 and applied the average
    annual growth rate from 2000-2008. To estimate potential 2009
    discretionary federal programs, we reviewed Palau's 2008 budget and
    assumed the same level of programs would be provided in 2009, adjusted
    for inflation. Similarly, we assumed the 2009 level of compact direct
    assistance and U.S. cost of compact federal services would be the
    inflation-adjusted value of those provided in 2008, based on U.S.
    agency budget data.

    [C] Discretionary federal programs exclude those provided in kind, such
    as DOD's Civic Action Team program.

    [D] Operating expenditure includes current expenditures and debt
    service and excludes investment management fees.

    [E] Net investments include the net change in the fair value of
    investments minus investment management fees.

    [F] The U.S. cost of compact federal services is based on U.S. agency
    budget data.

    [End of table]

    Table 7: Economic and Fiscal Data for the Three Compact Countries:

    Economic statistics, FY 2006[A]: Population;
    Palau: 20,580;
    FSM: 108,000;
    RMI: 52,710.

    Economic statistics, FY 2006[A]: GDP per capita:
    Palau: $7,500;
    FSM: $2,190;
    RMI: $2,730.

    Economic statistics, FY 2006[A]: GDP (thousands):
    Palau: $154,430;
    FSM: $236,900;
    RMI: $144,140.

    Economic statistics, FY 2006[A]: Foreign assistance (thousands)[B]:
    Palau: $44,350;
    FSM: $85,300;
    RMI: $58,500.

    Economic statistics, FY 2006[A]: Aid per capita:
    Palau: $2,160;
    FSM: $790;
    RMI: $1,110.

    Economic statistics, FY 2006[A]: International visitor arrivals[C]:
    Palau: 82,400;
    FSM: 19,280;
    RMI: 9,170.

    Economic statistics, FY 2006[A]: Remittances as a percentage of GDP[C]:
    Palau: -5.5%;
    FSM: 2.5%;
    RMI: 0.3%.

    Fiscal statistics, FY 2006[A]: Government tax revenue as a percentage
    of GDP:
    Palau: 19%;
    FSM: 13%;
    RMI: 17%.

    Fiscal statistics, FY 2006[A]: Government expenditure as percentage of
    GDP:
    Palau: 58%;
    FSM: 65%;
    RMI: 65%.

    Fiscal statistics, FY 2006[A]: Total public sector employee earnings as
    percentage of GDP[D]:
    Palau: 29%;
    FSM: 33%;
    RMI: 36%.

    Fiscal statistics, FY 2006[A]: Average public sector wage level ($US):
    Palau: $11,900;
    FSM: $8,850;
    RMI: $11,330.

    Fiscal statistics, FY 2006[A]: Average private sector wage level ($US):
    Palau: $6,380;
    FSM: $4,150;
    RMI: $5,070.

    Total U.S. assistance levels: Total compact grant assistance provided
    under initial compact (billions)[E]:
    Palau: $0.6;
    FSM: $1.5;
    RMI: $0.7.

    Total U.S. assistance levels: Total compact grant assistance provided
    under amended compact (billions)[E]:
    Palau: [Empty];
    FSM: $1.6;
    RMI: $1.1.

    Total U.S. assistance levels: Total U.S. trust fund contribution
    (millions)[F]:
    Palau: $70;
    FSM: $508;
    RMI: $271.

    Total U.S. assistance levels: Foreign assistance as percentage of
    national government revenue, 2000-2006 average[B]:
    Palau: 50%;
    FSM: 65%;
    RMI: 64%.

    Total U.S. assistance levels: Average annual level of discretionary
    federal programs, 2002-2004 (millions):
    Palau: $9;
    FSM: $45;
    RMI: $20.

    Source: Country compact reports, single audit data, and GAO estimates.

    [A] All data is rounded to the nearest tenth. Fiscal data for Palau and
    the Republic of the Marshall Islands (RMI) are for the national
    government and for the Federated States of Micronesia (FSM) are for the
    consolidated government, including states. Years cited are fiscal years
    (Oct. 1-Sept. 30).

    [B] Excludes in-kind foreign assistance.

    [C] Data for remittances and RMI international visitor arrivals is for
    2005.

    [D] Total public sector employee earnings include data for the
    national, state, and local governments plus government agencies and
    component units in all three countries.

    [E] The initial compact for Palau provided assistance for 15 years. The
    initial compact for the RMI and the FSM provided assistance for 17
    years. Data for U.S. assistance provided under the compacts of free
    association exclude the value of compact federal services and
    discretionary federal programs, but include Kwajalein impact payments
    to the RMI and the U.S. compact road to Palau.

    [F] The United States provided funding for a trust fund for Palau under
    the initial compact. The United States provided funding for trust funds
    for the FSM and the RMI under the amended compacts.

    [End of table]

    [End of section]

    Appendix IV: Technical Notes on the Trust Fund Simulation Model:

    This appendix lists the key inputs that we used to simulate the trust
    fund income and balance for 2010 to 2044 and some key simulation
    results. The key inputs include: (1) the trust fund's balances at the
    beginning of the projection, (2) disbursement and inflation adjustment,
    (3) the trust fund balance projection equation, and (4) distribution of
    returns for the Monte Carlo simulation. Further, this appendix contains
    a table comparing the nominal and real compounded returns of a
    portfolio based on the Palau trust fund asset allocation during various
    time periods.

    Key Simulation Inputs:

    1. Trust Fund Balance at the Beginning of the Projection:

    Our projection starts with an account balance of $160.755 million as of
    March 2008. This balance is higher than the projection in the trust
    fund agreement, which shows the account balance at the end of 2008 to
    be $123 million (if disbursement happens at the beginning of the year)
    and $144 million (if disbursement happens at the end of the year).
    However, the projection table in the trust fund agreement contains
    errors. It shows the annual disbursement of $5 million starting from
    the effective date of the compact (1995), rather than from the fourth
    anniversary of the effective date of the compact (1999), as the compact
    calls for. Also, it did not include the additional $4 million U.S.
    contribution, which was made during the third year after the effective
    date of the compact (1997). We corrected these errors and then applied
    the return (12.5 percent) assumed in the trust fund agreement. We
    calculate that this would result in an end of 2008 balance of $268
    million (if disbursement happens at the end of the year) or $259
    million (if disbursement happens at the beginning of the year). These
    were both higher than the actual account balance as of March 2008. We
    also projected the balance at the end of 2009, which is $297 million
    (if disbursement happens at the end of the year) or $285 million (if
    disbursement happens at the beginning of the year); this is far less
    than the projected $390 million that Palau indicated should be in the
    trust fund during its March 2008 meeting with the United States.

    2. Disbursement and Inflation Adjustment:

    Our projection assumes the disbursement is $15 million a year and the
    disbursement happens on a quarterly basis.[Footnote 78] In their
    projections, both the IMF and the Palau trust fund investment advisor
    assumed that the disbursements are inflation adjusted. However, the
    compact does not specify that the trust fund disbursement be inflation
    adjusted.[Footnote 79]

    3. Trust Fund Balance Projection Equation:

    In order to project the trust fund balances beyond 2008, we used the
    following projection equation: W_t+1= W_t * (1+r_t)*(1-F_t)-AW_t, where:

    W_t+1 = value of the fund at the beginning of period t+1;
    W_t = value of the fund at the beginning of period t;
    r_t = the quarterly return in period t;
    AW_t = the quarterly withdrawal in period t;
    F_t = the fees as a percentage of account value the trust fund pays to
    its trustee, investment advisor, money managers, and lawyers, etc. (We
    assume the fees to be 1 percent of the account value annually.)

    4. Distribution of Returns for Monte Carlo Simulation:

    Monte Carlo Simulation:

    Our methodology for projecting trust fund income is based on a
    technique known as the Monte Carlo simulation. This problem-solving
    technique approximates the probability of certain outcomes by
    performing multiple trial runs, called simulations, using random
    variables. The simulations capture the volatility of market returns and
    reflect that volatility in the projection of the future earnings of the
    trust fund. GAO has used the Monte Carlo simulation in past reports,
    including assessments of the FSM and the RMI trust funds, and it also
    has been used by the Congressional Budget Office in Social Security
    projections.

    We assume that future returns on the trust fund are randomly drawn from
    custom distributions, which are based on historical nominal returns for
    1970-2007 of the various asset classes and the proportion of the asset
    in the investment strategy. The distributions for small company stocks,
    large company stocks, and U.S. Treasury bills are illustrated in table
    8. The returns were published in Stocks, Bonds, Bills and Inflation
    (SBBI) 2008 Yearbook, by Ibbotson Associates.

    Table 8: Nominal Returns Distribution Based on Historical Data, 1970-
    2007:

    Small company stocks (%):

    Range: -30.9; -21.56;
    Probability: 2.70.

    Range: -21.56; -19.95;
    Probability: 2.70;

    Range: -19.95; -17.43;
    Probability: 2.70;

    Range: -17.43; -13.28;
    Probability: 2.70.

    Range: -13.28; -9.3;
    Probability: 2.70.

    Range: -9.3; -7.31;
    Probability: 2.70.

    Range: -7.31; -6.67;
    Probability: 2.70.

    Range: -6.67; -5.22;
    Probability: 2.70.

    Range: -5.22; -3.59;
    Probability: 2.70.

    Range: -3.59; 3.11;
    Probability: 2.70.

    Range: 3.11; 4.43;
    Probability: 2.70.

    Range: 4.43; 5.69;
    Probability: 2.70.

    Range: 5.69; 6.85;
    Probability: 2.70.

    Range: 6.85; 10.18;
    Probability: 2.70.

    Range: 10.18; 13.88;
    Probability: 2.70.

    Range: 13.88; 16.17;
    Probability: 2.70.

    Range: 16.17; 16.5;
    Probability: 2.70.

    Range: 16.5; 17.62;
    Probability: 2.70.

    Range: 17.62; 18.39;
    Probability: 2.70.

    Range: 18.39; 20.98;
    Probability: 2.70.

    Range: 20.98; 22.77;
    Probability: 2.70.

    Range: 22.77; 22.78;
    Probability: 2.70.

    Range: 22.78; 22.87;
    Probability: 2.70.

    Range: 22.87; 23.35;
    Probability: 2.70.

    Range: 23.35; 23.46;
    Probability: 2.70.

    Range: 23.46; 24.66;
    Probability: 2.70.

    Range: 24.66; 25.38;
    Probability: 2.70.

    Range: 25.38; 28.01;
    Probability: 2.70.

    Range: 28.01; 29.79;
    Probability: 2.70.

    Range: 29.79; 34.46;
    Probability: 2.70.

    Range: 34.46; 39.67;
    Probability: 2.70.

    Range: 39.67; 39.88;
    Probability: 2.70.

    Range: 39.88; 43.46;
    Probability: 2.70.

    Range: 43.46; 44.63;
    Probability: 2.70.

    Range: 44.63; 52.82;
    Probability: 2.70.

    Range: 52.82; 57.36;
    Probability: 2.70.

    Range: 57.36; 60.7;
    Probability: 2.70.

    Large company stocks (%):

    Range: -26.47; -22.1;
    Probability: 2.70.

    Range: -22.1; -14.66;
    Probability: 2.70.

    Range: -14.66; -11.88;
    Probability: 2.70.

    Range: -11.88; -9.11;
    Probability: 2.70.

    Range: -9.11; -7.18;
    Probability: 2.70.

    Range: -7.18; -4.91;
    Probability: 2.70.

    Range: -4.91; -3.17;
    Probability: 2.70.

    Range: -3.17; 1.31;
    Probability: 2.70.

    Range: 1.31; 4.01;
    Probability: 2.70.

    Range: 4.01; 4.91;
    Probability: 2.70.

    Range: 4.91; 5.23;
    Probability: 2.70.

    Range: 5.23; 5.49;
    Probability: 2.70.

    Range: 5.49; 6.27;
    Probability: 2.70.

    Range: 6.27; 6.56;
    Probability: 2.70.

    Range: 6.56; 7.67;
    Probability: 2.70.

    Range: 7.67; 9.99;
    Probability: 2.70.

    Range: 9.99; 10.87;
    Probability: 2.70.

    Range: 10.87; 14.31;
    Probability: 2.70.

    Range: 14.31; 15.8;
    Probability: 2.70.

    Range: 15.8; 16.81;
    Probability: 2.70.

    Range: 16.81; 18.44;
    Probability: 2.70.

    Range: 18.44; 18.47;
    Probability: 2.70.

    Range: 18.47; 18.98;
    Probability: 2.70.

    Range: 18.98; 21.04;
    Probability: 2.70.

    Range: 21.04; 21.41;
    Probability: 2.70.

    Range: 21.41; 22.51;
    Probability: 2.70.

    Range: 22.51; 23.07;
    Probability: 2.70.

    Range: 23.07; 23.84;
    Probability: 2.70.

    Range: 23.84; 28.58;
    Probability: 2.70.

    Range: 28.58; 28.7;
    Probability: 2.70.

    Range: 28.7; 30.55;
    Probability: 2.70.

    Range: 30.55; 31.49;
    Probability: 2.70.

    Range: 31.49; 32.16;
    Probability: 2.70.

    Range: 32.16; 32.42;
    Probability: 2.70.

    Range: 32.42; 33.36;
    Probability: 2.70.

    Range: 33.36; 37.2;
    Probability: 2.70.

    Range: 37.2; 37.43;
    Probability: 2.70.

    U.S. Treasury bills (%):

    Range: 1.02; 1.2;
    Probability: 2.70.

    Range: 1.2; 1.65;
    Probability: 2.70.

    Range: 1.65; 2.9;
    Probability: 2.70.

    Range: 2.9; 2.98;
    Probability: 2.70.

    Range: 2.98; 3.51;
    Probability: 2.70.

    Range: 3.51; 3.83;
    Probability: 2.70.

    Range: 3.83; 3.84;
    Probability: 2.70.

    Range: 3.84; 3.9;
    Probability: 2.70.

    Range: 3.9; 4.39;
    Probability: 2.70.

    Range: 4.39; 4.66;
    Probability: 2.70.

    Range: 4.66; 4.68;
    Probability: 2.70.

    Range: 4.68; 4.8;
    Probability: 2.70.

    Range: 4.8; 4.86;
    Probability: 2.70.

    Range: 4.86; 5.08;
    Probability: 2.70.

    Range: 5.08; 5.12;
    Probability: 2.70.

    Range: 5.12; 5.21;
    Probability: 2.70.

    Range: 5.21; 5.26;
    Probability: 2.70.

    Range: 5.26; 5.47;
    Probability: 2.70.

    Range: 5.47; 5.61;
    Probability: 2.70.

    Range: 5.61; 5.65;
    Probability: 2.70.

    Range: 5.65; 5.8;
    Probability: 2.70.

    Range: 5.8; 5.89;
    Probability: 2.70.

    Range: 5.89; 6.16;
    Probability: 2.70.

    Range: 6.16; 6.35;
    Probability: 2.70.

    Range: 6.35; 6.52;
    Probability: 2.70.

    Range: 6.52; 6.93;
    Probability: 2.70.

    Range: 6.93; 7.18;
    Probability: 2.70.

    Range: 7.18; 7.72;
    Probability: 2.70.

    Range: 7.72; 7.81;
    Probability: 2.70.

    Range: 7.81; 8;
    Probability: 2.70.

    Range: 8; 8.37;
    Probability: 2.70.

    Range: 8.37; 8.8;
    Probability: 2.70.

    Range: 8.8; 9.85;
    Probability: 2.70.

    Range: 9.85; 10.38;
    Probability: 2.70.

    Range: 10.38; 10.54;
    Probability: 2.70.

    Range: 10.54; 11.24;
    Probability: 2.70.

    Range: 11.24; 14.71;
    Probability: 2.70.

    Source: GAO calculation.

    [End of table]

    Cross-correlation and serial correlation are built into the Monte Carlo
    random draws to capture the co-movement across the asset classes and
    over time. (See table 9.)

    Table 9: Cross-Correlation and Serial Correlation of Historical Annual
    Returns:

    Small company:
    Small company: 1;
    Large company: [Empty];
    U.S. Treasury bills: [Empty].

    Large company:
    Small company: 0.66;
    Large company: 1;
    U.S. Treasury bills: [Empty].

    U.S. Treasury bills:
    Small company: -0.01;
    Large company: 0.05;
    U.S. Treasury bills: 1.

    Serial correlation:
    Small company: -0.003;
    Large company: 0.03;
    U.S. Treasury bills: 0.81.

    Source: GAO calculation.

    [End of table]

    The annual compounded returns and standard deviations for the various
    asset classes are shown in the table 10.

    Table 10: Annual Compounded Returns and Standard Deviations for Large
    Company and Small Company Stocks and for U.S. Treasury Bills (in
    percentage), 1970-2007:

    Compounded nominal returns:
    Small company: 13;
    Large company: 11;
    U.S. Treasury bills: 6.

    Standard deviation:
    Small company: 23;
    Large company: 17;
    U.S. Treasury bills: 3.

    Strategic asset allocation in Palau trust fund[A]:
    Small company: 15;
    Large company: 50;
    U.S. Treasury bills: 35.

    Source: GAO analysis based on Ibbotson 2008 Yearbook.

    [A] This was the strategic asset allocation as of September 2007. It
    may change over time.

    [End of table]

    Monte Carlo Simulation Results:

    Each year's return is randomly selected from the return distribution of
    each asset class. The simulation is run 10,000 times, yielding 10,000
    possible outcomes and providing a distribution of annual investment
    income, account balance, and disbursements. (Table 11 shows the first
    20 trial values from the simulation of the trust fund account balance.)

    Table 11: Trial Values of the Palau Trust Fund Balance, 2025-2044:
    (Dollars in millions):

    Trial value: 1;
    2025: $62;
    2026: $56;
    2027: $48;
    2028: $42;
    2029: $29;
    2030: $18;
    2031: 4;
    2032: 0;
    2033: 0;
    2034: 0;
    2035: 0;
    2036: 0;
    2037: 0;
    2038: 0;
    2039: 0;
    2040: 0;
    2041: 0;
    2042: 0;
    2043: 0;
    2044: 0.

    Trial value: 2;
    2025: $258;
    2026: $305;
    2027: $337;
    2028: $338;
    2029: $402;
    2030: $442;
    2031: $484;
    2032: $516;
    2033: $589;
    2034: $641;
    2035: $762;
    2036: $915;
    2037: $1,013;
    2038: $1,112;
    2039: $1,304;
    2040: $1,494;
    2041: $1,843;
    2042: $2,134;
    2043: $2,477;
    2044: $2,818.

    Trial value: 3;
    2025: $93;
    2026: $75;
    2027: $59;
    2028: $49;
    2029: $44;
    2030: $24;
    2031: $11;
    2032: $1;
    2033: 0;
    2034: 0;
    2035: 0;
    2036: 0;
    2037: 0;
    2038: 0;
    2039: 0;
    2040: 0;
    2041: 0;
    2042: 0;
    2043: 0;
    2044: 0.

    Trial value: 4;
    2025: $467;
    2026: $509;
    2027: $571;
    2028: $602;
    2029: $677;
    2030: $770;
    2031: $860;
    2032: $843;
    2033: $924;
    2034: $1,121;
    2035: $1,010;
    2036: $1,114;
    2037: $1,202;
    2038: $1,179;
    2039: $1,34;
    2040: $1,184;
    2041: $1,267;
    2042: $1,284;
    2043: $1,540;
    2044: $1,615.

    Trial value: 5;
    2025: $193;
    2026: $173;
    2027: $149;
    2028: $143;
    2029: $146;
    2030: $140;
    2031: $147;
    2032: $149;
    2033: $145;
    2034: $163;
    2035: $164;
    2036: $158;
    2037: $150;
    2038: $152;
    2039: $138;
    2040: $130;
    2041: $147;
    2042: $147;
    2043: $152;
    2044: $155.

    Trial value: 6;
    2025: $175;
    2026: $174;
    2027: $159;
    2028: $148;
    2029: $122;
    2030: $120;
    2031: $98;
    2032: $68;
    2033: $54;
    2034: $39;
    2035: $30;
    2036: $20;
    2037: $8;
    2038: 0;
    2039: 0;
    2040: 0;
    2041: 0;
    2042: 0;
    2043: 0;
    2044: 0.

    Trial value: 7;
    2025: $142;
    2026: $131;
    2027: $141;
    2028: $147;
    2029: $131;
    2030: $146;
    2031: $169;
    2032: $160;
    2033: $133;
    2034: $130;
    2035: $125;
    2036: $129;
    2037: $107;
    2038: $97;
    2039: $99;
    2040: $101;
    2041: $110;
    2042: $115;
    2043: $115;
    2044: $118.

    Trial value: 8;
    2025: $135;
    2026: $124;
    2027: $130;
    2028: $143;
    2029: $134;
    2030: $152;
    2031: $166;
    2032: $180;
    2033: $177;
    2034: $181;
    2035: $155;
    2036: $161;
    2037: $138;
    2038: $118;
    2039: $123;
    2040: $138;
    2041: $116;
    2042: $119;
    2043: $110;
    2044: $116.

    Trial value: 9;
    2025: $428;
    2026: $385;
    2027: $384;
    2028: $431;
    2029: $458;
    2030: $469;
    2031: $413;
    2032: $513;
    2033: $502;
    2034: $579;
    2035: $631;
    2036: $692;
    2037: $683;
    2038: $608;
    2039: $640;
    2040: $686;
    2041: $762;
    2042: $706;
    2043: $753;
    2044: $933.

    Trial value: 10;
    2025: $764;
    2026: $872;
    2027: $878;
    2028: $918;
    2029: $1,028;
    2030: $1,087;
    2031: $1,306;
    2032: $1,303;
    2033: $1,344;
    2034: $1,573;
    2035: $1,749;
    2036: $1,860;
    2037: $2,244;
    2038: $2,674;
    2039: $2,925;
    2040: $3,065;
    2041: $3,536;
    2042: $4,022;
    2043: $4,934;
    2044: $4,777.

    Trial value: 11;
    2025: $129;
    2026: $111;
    2027: $105;
    2028: $109;
    2029: $86;
    2030: $73;
    2031: $68;
    2032: $63;
    2033: $56;
    2034: $54;
    2035: $44;
    2036: $32;
    2037: $22;
    2038: $8;
    2039: 0;
    2040: 0;
    2041: 0;
    2042: 0;
    2043: 0;
    2044: 0.

    Trial value: 12;
    2025: 0;
    2026: 0;
    2027: 0;
    2028: 0;
    2029: 0;
    2030: 0;
    2031: 0;
    2032: 0;
    2033: 0;
    2034: 0;
    2035: 0;
    2036: 0;
    2037: 0;
    2038: 0;
    2039: 0;
    2040: 0;
    2041: 0;
    2042: 0;
    2043: 0;
    2044: 0.

    Trial value: 13;
    2025: $139;
    2026: $135;
    2027: $154;
    2028: $131;
    2029: $107;
    2030: $92;
    2031: $91;
    2032: $74;
    2033: $49;
    2034: $40;
    2035: $25;
    2036: $13;
    2037: $1;
    2038: 0;
    2039: 0;
    2040: 0;
    2041: 0;
    2042: 0;
    2043: 0;
    2044: 0.

    Trial value: 14;
    2025: $424;
    2026: $472;
    2027: $576;
    2028: $605;
    2029: $666;
    2030: $761;
    2031: $767;
    2032: $775;
    2033: $818;
    2034: $972;
    2035: $1,139;
    2036: $986;
    2037: $982;
    2038: $899;
    2039: $1,102;
    2040: $1,235;
    2041: $1,447;
    2042: $1,599;
    2043: $1,896;
    2044: $2,069.

    Trial value: 15;
    2025: $58;
    2026: $50;
    2027: $39;
    2028: $32;
    2029: $20;
    2030: $6;
    2031: 0;
    2032: 0;
    2033: 0;
    2034: 0;
    2035: 0;
    2036: 0;
    2037: 0;
    2038: 0;
    2039: 0;
    2040: 0;
    2041: 0;
    2042: 0;
    2043: 0;
    2044: 0.

    Trial value: 16;
    2025: 0;
    2026: 0;
    2027: 0;
    2028: 0;
    2029: 0;
    2030: 0;
    2031: 0;
    2032: 0;
    2033: 0;
    2034: 0;
    2035: 0;
    2036: 0;
    2037: 0;
    2038: 0;
    2039: 0;
    2040: 0;
    2041: 0;
    2042: 0;
    2043: 0;
    2044: 0.

    Trial value: 17;
    2025: $37;
    2026: $19;
    2027: $7;
    2028: 0;
    2029: 0;
    2030: 0;
    2031: 0;
    2032: 0;
    2033: 0;
    2034: 0;
    2035: 0;
    2036: 0;
    2037: 0;
    2038: 0;
    2039: 0;
    2040: 0;
    2041: 0;
    2042: 0;
    2043: 0;
    2044: 0.

    Trial value: 18;
    2025: $80;
    2026: $70;
    2027: $66;
    2028: $60;
    2029: $48;
    2030: $40;
    2031: $23;
    2032: $9;
    2033: 0;
    2034: 0;
    2035: 0;
    2036: 0;
    2037: 0;
    2038: 0;
    2039: 0;
    2040: 0;
    2041: 0;
    2042: 0;
    2043: 0;
    2044: 0.

    Trial value: 19;
    2025: $14;
    2026: $2;
    2027: 0;
    2028: 0;
    2029: 0;
    2030: 0;
    2031: 0;
    2032: 0;
    2033: 0;
    2034: 0;
    2035: 0;
    2036: 0;
    2037: 0;
    2038: 0;
    2039: 0;
    2040: 0;
    2041: 0;
    2042: 0;
    2043: 0;
    2044: 0.

    Trial value: 20;
    2025: $217;
    2026: $188;
    2027: $156;
    2028: $150;
    2029: $153;
    2030: $127;
    2031: $123;
    2032: $112;
    2033: $100;
    2034: $79;
    2035: $57;
    2036: $50;
    2037: $39;
    2038: $21;
    2039: $6;
    2040: 0;
    2041: 0;
    2042: 0;
    2043: 0;
    2044: 0.

    Trial value: Median;
    2025: $147;
    2026: $144;
    2027: $142;
    2028: $140;
    2029: $135;
    2030: $130;
    2031: $127;
    2032: $122;
    2033: $118;
    2034: $112;
    2035: $106;
    2036: $100;
    2037: $93;
    2038: $84;
    2039: $75;
    2040: $66;
    2041: $56;
    2042: $46;
    2043: $34;
    2044: $22.

    Trial value: 10th percentile;
    2025: 0;
    2026: 0;
    2027: 0;
    2028: 0;
    2029: 0;
    2030: 0;
    2031: 0;
    2032: 0;
    2033: 0;
    2034: 0;
    2035: 0;
    2036: 0;
    2037: 0;
    2038: 0;
    2039: 0;
    2040: 0;
    2041: 0;
    2042: 0;
    2043: 0;
    2044: 0.

    Trial value: 90th percentile;
    2025: $416;
    2026: $443;
    2027: $469;
    2028: $502;
    2029: $536;
    2030: $576;
    2031: $612;
    2032: $661;
    2033: $708;
    2034: $762;
    2035: $819;
    2036: $887;
    2037: $961;
    2038: $1,025;
    2039: $1,109;
    2040: $1,201;
    2041: $1,304;
    2042: $1,419;
    2043: $1,538;
    2044: $1,649.

    Source: GAO analysis.

    Note: Years cited are fiscal years (Oct. 1-Sept. 30).

    [End of table]

    Historical Returns of a Portfolio Based on Palau Trust Fund Asset
    Allocation with Various Time Periods:

    Forecasts of future returns are subject to considerable uncertainty.
    The historical rates of return for the asset classes held in the fund's
    portfolio differ depending on the time period considered, as
    illustrated in table 12.

    Table 12: Historical Rates of Return of a Portfolio Based on the Palau
    Trust Fund Asset Allocation (in percentage):

    Period: 1926-2007;
    Nominal Returns: 8.08;
    Rate of Inflation: 3.05;
    Real Returns: 4.86.

    Period: 1970-2007;
    Nominal Returns: 9.08;
    Rate of Inflation: 4.62;
    Real Returns: 4.29.

    Period: 1988-2007;
    Nominal Returns: 8.88; R
    ate of Inflation: 3.04;
    Real Returns: 5.80.

    Period: 1998-2007;
    Nominal Returns: 5.23;
    Rate of Inflation: 2.68;
    Real Returns: 2.52.

    Source: GAO calculation.

    Note: To calculate the compounded returns, we used the annual nominal
    returns published in the Ibbotson Associates 2008 Yearbook. We
    rebalance the portfolio annually to maintain the asset allocation of 50
    percent in U.S. large capital funds, 15 percent in U.S. small capital
    funds, and 35 percent in fixed income assets. The returns are net of
    fees and commissions, which we assume to be 1 percent annually.

    [End of table]

    [End of section]

    Appendix V: Compact Road:

    Stakeholders responsible for building a road system on Palau
    encountered challenges in planning and constructing the road, including
    changes in the project's scope, decisions about locating the route, and
    difficult geographical and environmental conditions. In large part
    because of these challenges, the construction of a 53-mile road for
    Palau, which was built to U.S. standards (see fig. 8), was completed 7
    years later than planned. The government of Palau is now responsible
    for the road and faces challenges in managing and funding its operation
    and maintenance. Palau has made some initial efforts to maintain the
    road, but both U.S. and Palau officials are concerned that the
    government of Palau has not sufficiently funded the necessary
    maintenance. Without such maintenance, the road will deteriorate over
    time and may not provide the economic development benefits envisioned
    for the people of Palau.

    Figure 8: Compact Road at Beginning and End of Construction:

    [See PDF for image]

    This figure contains before and after pictures of the Compact Road.

    Source: USACE.

    [End of figure]

    Background:

    To assist Palau in its efforts to advance its economic development and
    self-sufficiency, the Compact of Free Association between the United
    States and Palau called for the United States to build a road system
    (compact road) in Palau according to mutually agreed-upon
    specifications before October 1, 2000. The road was completed and
    turned over to Palau on October 1, 2007. While Interior's Office of
    Insular Affairs budgeted $149 million for the project, the cost
    incurred thus far is approximately $144 million.[Footnote 80] Palau
    contributed to the project by preparing, negotiating, and acquiring
    more than 2,000 easements for the road at no cost. U.S. and Palau
    officials expressed their satisfaction with the completed road.
    [Footnote 81]

    After completing the compact road, the United States turned it over to
    Palau, which is responsible for operating and maintaining it.[Footnote
    82] In August 2005, the USACE delivered a plan to Palau authorities for
    operating and maintaining the road. The plan provides options for Palau
    to develop maintenance methodologies that can result in the lowest long-
    term maintenance costs. The plan also provides options for developing a
    funding mechanism to support the operation and maintenance of the road,
    including a "user pays" concept.

    Scope Changes, Route Location Decisions, and Difficult Geographical and
    Environmental Conditions Presented Challenges in Designing and
    Constructing the Road:

    According to USACE officials,[Footnote 83] negotiations over the
    project's scope presented challenges in designing the compact road,
    extending the time required to finalize the design. Early in the
    project, Palau requested and negotiated with the United States a change
    that expanded the scope of the project from a 53-mile, 18-foot-wide
    double bituminous surface treatment road[Footnote 84] with 2-foot-wide
    shoulders, as originally agreed, to a 53-mile, 24-foot-wide paved road
    with 4-foot-wide shoulders.[Footnote 85] U.S. legislation passed in
    April 1996 authorized the Secretary of the Interior to agree to
    technical changes to the road, as long as the United States did not
    incur any additional costs, enabling U.S. and Palau stakeholders to
    negotiate changes to the project.[Footnote 86]

    Identifying and agreeing on an acceptable route for the compact road
    posed further challenges in designing the project, according to
    Interior and USACE officials. The route had to be approved by the
    government of Palau and meet engineering feasibility requirements. The
    government of Palau eventually decided to build a road to form a ring
    around the island of Babeldaob, providing road access to all 10 states
    on the island (see fig. 9).[Footnote 87] The design also includes a
    spur at the north end of the island.

    Figure 9: Map of Palau Roads and States:

    [See PDF for image]

    This figure is a map of Palau roads and states, depicting the Compact
    road and other roads. There is also an inset map of the Koror area.
    Areas specifically indicated on the map include:
    Ngarchelong;
    Ngaraard;
    Ngiwal;
    Melekeok;
    Capitol of Palau;
    Ngchesar;
    Airai;
    Palau International Airport;
    Koror;
    Aimeliik;
    Ngatpang;
    Mgaremlengui;
    Ngardmau.

    Source: GAO presentation of Palau Government, USACE, and U.S.Geological
    Survey data.

    [End of figure]

    During the project's construction, stakeholders encountered challenges
    associated with Palau's geographic location and environment. Getting
    equipment, materials, and manpower to the island on time proved
    difficult.[Footnote 88] In addition, USACE had to arrange for the
    removal and destruction of 5,500 rounds of ordinance dating from World
    War II during construction. Palau's rugged peak and valley terrain,
    dense jungle, tropical weather, and poor soil quality further
    complicated construction efforts. For example, the valleys had to be
    filled and the hillsides cut in peak areas along the route to create a
    grade for the road consistent with U.S. standards (see fig. 10).
    Tropical rains, combined with the high moisture content of the soils
    used for fill material, made it difficult to get the compaction needed
    to keep the pavement from settling later. In addition, the rain and
    poor soils together caused many landslides, referred to as cut slope
    failures, along the road during construction.[Footnote 89] Such
    failures continued to occur after sections of the road were initially
    completed; however, according to a USACE official, there have been no
    new failures since October 2007, when Palau accepted the compact road
    and assumed responsibility for maintaining it.

    Figure 10: Compact Road Construction Terrain and Cut Slope Failure:

    [See PDF for image]

    This figure contains two photograph depicting Compact Road construction
    terrain and cut slope failure.

    Source: USACE.

    [End of figure]

    Compact Road Was Completed Late but Did Not Exceed USACE's Original
    Cost Estimate:

    The compact road--which was to be completed within 6 years of October
    1994, the effective date of the compact between the United States and
    Palau--was turned over to Palau October 2007, 13 years after the
    compact's effective date (see fig. 11). It took almost 2 years from the
    effective date to award design contracts, approximately 2 years to
    design the project, and approximately 9 years to construct the road.
    When we reviewed the site, we found the road completed and open to
    traffic, with only a few deficiencies: For example, the road had
    settled at the end of one bridge and water was seeping out between the
    road and the adjoining shoulder at other locations. USACE is
    investigating the cause of the settlement to determine if it is covered
    by the contractor warranty. In addition, drains are being added along
    the road under the shoulder in water seepage areas to carry water away
    from the road and eliminate the seepage, which could cause future
    maintenance problems by weakening ground support for the road pavement.

    Figure 11: Compact Road Project Timeline:

    [See PDF for image]

    The timeline depicts the following dates and events:

    1994:
    April: Start-up of project discussed between Interior and USACE;
    October: Effective date of the compact.

    1995:
    March: Interior and USACE begin program and project management
    agreement negotiations;
    September: First project cost estimate by USACE;
    October: Interior approved program funding at $149 million;
    November: First road survey contract awarded.

    1996:
    January: First environmental consultant contract awarded;
    April: Congress passes law allowing for project scope change;
    November: Road design consultant contracts awarded.

    [Design phase from late 1996 to late 1998]

    1997:
    August: First geotechnical[A] consultant contract awarded.

    [Construction phase from mid 1998 to mid 2007]

    1998:
    July: Environmental impact statement completed;
    August: Request for proposals for construction issued.

    1999:
    March: Road construction contract awarded;
    June: Partial construction notice to proceed (mobilization);
    November: Full construction notice to proceed.

    2000:
    March: Environmental Quality Protection Board earth-moving permit
    issued;
    October: Compact-specified road completion date.

    2002:
    December: Revised construction contract completion date.

    2003:
    October: Original construction contract completion date.

    2007:
    October: Formal road completion and turnover to Palau.

    2008:
    August: End of road warranty period.

    Source: GAO, Interior, and USACE.

    [A] Geotechnical consultants use borings to analyze the below-ground
    conditions of the soil, rock, and water tables to assist road designers
    in determining how the road should be designed and constructed.

    [End of figure]

    USACE officials reported that U.S. costs for the project were within
    USACE's September 1995 estimate of $149 million.[Footnote 90] That
    estimate was used to create a program budget of $25 million for design
    and design supervision and $124 million for construction and
    construction supervision. While the scope of the project was
    substantially increased, its costs did not exceed USACE's estimate
    because of what an Interior official described as a very competitive
    bidding environment, which allowed the construction contract to be
    awarded at a lower-than-expected cost. Contractors' original
    construction proposals ranged from $73 million to $220 million and a
    contract was awarded for $88.6 million. According to USACE officials,
    construction contract modifications have since increased the cost of
    the construction contract to $107.6 million. In total, USACE has
    expended approximately $138.8 million for the project's design and
    construction, and about $5.1 million in contractual obligations for
    design and construction work remain.[Footnote 91] However, the project
    is currently the subject of a construction contract dispute between the
    United States and the construction contractor, and the final U.S. cost
    of the project cannot be determined until appeals by the construction
    contractor are resolved.[Footnote 92]

    Management and Funding Challenges Hinder Palau's Ongoing Efforts to
    Maintain the Road:

    Now that the government of Palau, through its Bureau of Public Works,
    is responsible for the compact road's operation and maintenance, it
    faces management and funding challenges. Palau has made initial efforts
    to maintain the road, but U.S. and Palau officials are concerned about
    Palau's ability to provide sufficient funding to maintain the road in a
    condition that supports the desired economic development.

    U.S. Government Provided Road Maintenance Training and Operations and
    Maintenance Plan:

    Long before turning the compact road over to Palau in October 2007, the
    U.S. government provided Palau with training and a plan for operations
    and maintenance. Specifically, Interior partnered with Palau Community
    College in late 1999 and early 2000 to provide training in road
    maintenance techniques. An Interior official told us that subsequent to
    the initial training, Interior offered additional maintenance training
    using technical assistance funding, but Palau has not taken Interior up
    on the offer. Additionally, in August 2005, USACE--as required by the
    subsidiary construction projects agreement--provided Palau with the
    Operation and Maintenance Plan for the Palau Compact Road. This plan,
    which a USACE consultant developed primarily from information provided
    by an industry group that supports U.S. state highway maintenance
    efforts, includes a strategy and guidance for Palau to develop its own
    detailed program for successfully operating and maintaining the road.
    The plan cautions that unless Palau adopts an aggressive maintenance
    program, the economic development opportunities made possible by the
    compact road will be short lived. Moreover, according to the plan,
    failure to provide timely maintenance will accelerate the road's
    deterioration, and more expensive road reconstruction may then be
    required. The plan estimates annual maintenance costs for the compact
    road that range from $1.5 million to $3 million. Those estimates cover
    the costs of recurrent maintenance tasks such as mowing, sign repair,
    and guardrail repair; overhead such as supervisory personnel, fuel, and
    supplies; capital investments such as equipment and storage yards;
    project maintenance such as asphalt seal coat treatments; and funds for
    natural and man-made disasters and emergencies.[Footnote 93] To
    minimize those costs, the plan recommends using cost-benefit analysis
    to develop least-cost methods of providing the operations and
    maintenance services. The plan also provides options for developing a
    funding mechanism for the operation and maintenance of the compact road
    including a "user pays" concept that would require the government of
    Palau to enact new taxes or increase existing taxes to adequately fund
    the road's operations and maintenance.

    Palau Faces Challenges in Managing the Compact Road's Maintenance
    According to the Plan:

    The Palau Bureau of Public Works has performed some maintenance
    activities, but not to the degree envisioned in the plan. Specifically,
    Palau workers, 21 of whom are currently assigned to maintain the
    compact road, according to Palau officials, have used string trimmers
    to cut the grass and weeds alongside the road (see fig. 12). During the
    3-month period from November 2007 through January 2008, they trimmed
    approximately 15 of the compact road's 53 miles. This level of
    production would not allow Palau to complete the mowing along the
    entire compact road every 3 months as the plan recommends.

    Figure 12: Grass-Cutting Crews and Damaged Guardrail:

    [See PDF for image]

    This figure contains two photographs.

    Source: GAO.

    [End of figure]

    Palau has not yet begun the full range of operation and maintenance
    activities set out in the plan, such as developing sign inventories,
    inspecting bridges, sealing cracks,[Footnote 94] or requiring permits
    for the public to install driveways, private signs, and other
    obstructions in the road right-of-way. Moreover, the Bureau of Public
    Works could provide only limited documentation of its maintenance
    activities to date, and this documentation did not include records of
    such actions as road maintenance work orders completed, miles of grass
    cut, or numbers of cut slope failures cleaned up.

    Our site review of the compact road found the road in very good
    condition except that weeds and grass were overgrowing portions of the
    roadway, potentially obstructing drivers' views in some places. In
    addition, several new private drives were being connected to the
    compact road that did not meet the compact road standards for private
    drives. In one case, a guardrail installed for safety had been removed.

    Funding Challenges Limit Palau's Ability to Maintain the Road:

    With the compact road, the maintenance workload of the Palau Bureau of
    Public Works has increased, but the budget for the Bureau has
    decreased. The compact road has more than tripled Palau's national road
    miles, increasing their number from 20 to 73. Yet the budget for the
    Bureau of Public Works has decreased from approximately $1.7 million
    for 2007 to about $1.5 million for 2008.[Footnote 95] For 2007, the
    Bureau's Bridge and Road Maintenance Branch had a budget of
    approximately $175,000, and that sum had not changed significantly for
    the last 5 years, according to a Palau official. The Ministry of
    Resources and Development received an additional $300,000 in its 2008
    budget specifically for road maintenance. This funding is separate from
    funding for the Ministry's Bureau of Public Works. Palau officials
    indicated that they plan to use this $300,000 for fuel, supplies, and
    some equipment. The plan suggests a minimum of $1.5 million annually
    for the maintenance of the compact road.

    Besides funding routine maintenance, Palau needs to maintain sufficient
    resources to provide emergency maintenance in the event of a typhoon or
    severe rain. Such emergencies may require repairs to bridges and
    drainage pipes, as well as cleanups of cut slope failures, fallen
    trees, and other debris to make the road operational. Between January
    30, 2007 and September 5, 2007, before USACE turned the compact road
    over to Palau, it awarded contracts totaling approximately $334,000 to
    clean up and repair cut slope failures along completed sections of the
    compact road. Such cleanups are now part of Palau's maintenance
    responsibility and must be done if the road is to remain safe and open
    to traffic. A USACE official reported that since September 5, 2007,
    only small soil slides have occurred at sites of previous cut slope
    failures, and the Bureau of Public Works cleaned these up with help
    from a local contractor.

    Palau has considered outsourcing some critical road maintenance tasks.
    In May 2007, Palau authorities issued a request for proposals for
    activities such as mowing services for the entire compact road,
    cleaning of bridges and drainage structures, and inspecting culverts
    and bridges. Under this proposal, the contractor would provide all
    equipment and manpower, reducing the need for Palau to purchase
    equipment and hire full-time employees. We found that at least one
    proposal was submitted to Palau to perform these services for 1 year at
    a cost of $371,069. The proposal also indicated how equipment would be
    used and how often maintenance activities would be performed. For
    example, grass would be cut along the entire compact road monthly.
    Palau officials, however, decided not to award a contract for
    maintenance services. Instead, they believed they had enough public
    sector workers to provide maintenance services for the first year.

    To help address its maintenance funding challenge, Palau has requested
    additional funding from the United States. In December 2007, Palau
    asked Interior for approximately $1 million to purchase equipment
    listed in the plan to mow, clean, and clear the road. When we asked a
    Palau official about Palau's plan for using the equipment, he said
    Palau does not have a specific plan for the equipment. Palau also had
    not considered the costs to maintain the equipment or how it would be
    utilized to justify its purchase and evaluate the effectiveness of its
    use.[Footnote 96] Palau also asked the United States to set aside a $3
    million debt Palau owes to the United States under section 211(b) of
    the compact to create a capital fund to finance the maintenance of the
    compact road. The U.S. Congress recently passed legislation that
    permits Palau to do so.[Footnote 97]

    Assistance in managing and funding the operation and maintenance of the
    compact road is available to Palau through guidance developed for local
    public works agencies in the United States. In contrast to the guidance
    for state highway agencies, on which the USACE consultant based the
    plan, this guidance exists for local public works agencies. With only
    73 miles of road to maintain, such guidance may be more appropriate for
    Palau than the state guidance, and using such guidance may help Palau
    fine tune its compact road operations and maintenance activities and
    budgets. For example, the National Association of County Engineers
    developed a guide for maintenance management and one for road surface
    management. In addition, the Transportation Information Center at the
    University of Wisconsin, Madison, has manuals for simplified road
    pavement surface evaluation. The Federal Highway Administration's Local
    and Tribal Technical Assistance Programs also provide a clearinghouse
    of information and training resources for local agencies responsible
    for roads and bridges. Much of this information is available at no cost
    through the Internet.

    [End of section]

    Appendix VI: Selected Federal Programs:

    This appendix provides additional information on discretionary federal
    programs with expenditures in Palau during 2006. We include additional
    information on selected federal programs to illustrate the diversity of
    U.S. federal program assistance in the areas of education, health, and
    infrastructure. Following the description of selected programs, Table
    13 lists discretionary U.S. federal program funds expended by the Palau
    national government, Palau Community College, and Palau Community
    Action Agency, as reported in the organizations' single audit reports
    for 2006.

    Department of Transportation: FAA Airport Improvement Program:

    Expenditures:

    * 2005: $1.62 million;
    * 2006: $9.40 million.

    Recipient: Government of Palau:

    Purpose and legislation: The Vision 100-Century of Aviation
    Reauthorization Act (Pub. L. No. 108-176, � 188, 117 Stat. 2490, 2519
    (2003)) made sponsors of airports in Palau eligible for grants from the
    Airport Improvement Program discretionary fund and the Small Airport
    Fund for 2004 through 2007. According to an Airport Improvement Program
    coordinator, the purpose of the Airport Improvement Program is to
    create or preserve airport assets and infrastructure. The Airport
    Improvement Program's reauthorization for 2008-2011 is currently
    pending before Congress.[Footnote 98]It contains language that would
    continue Palau's eligibility for funding through this program, and
    preparations are being made in Palau and at FAA to make further
    improvements to the airport if the bill is passed.

    Program observations: According to Airport Improvement Program
    managers, Palau's airport runway, prior to the FAA-funded improvements,
    was near closure due to critical aviation safety concerns. Airport
    Improvement Program funds have been used to rehabilitate the runway,
    taxiway, and signage; rehabilitate the airport apron and install two
    additional loading bridges; procure two aircraft rescue and fire-
    fighting vehicles and one rapid intervention vehicle; construct a new
    aircraft rescue and fire-fighting building; install perimeter security
    fencing; and develop an airport master plan. Agency officials told us
    that the Airport Improvement Program's 4-year investment in Palau, from
    2004-2007, totaled approximately $26 million. In commenting on this
    report, FAA noted that the FAA-funded improvements included grant
    assurances agreed to by the Palau government, which require continued
    maintenance and operations for the projected useful life of the
    facilities and equipment. Moreover, they said that the Palau government
    needs to staff the airport with trained and qualified aircraft rescue
    and firefighting personnel. They emphasized the need for safety at
    Palau's airport as U.S. carriers fly to Palau from several locations
    and use it as an emergency airport for overlying routes.

    Both agency officials and representatives from the government of Palau
    cited the improvements to the safety and capacity of the airport.
    According to agency officials, Palau has performed well in its
    management of Airport Improvement Program grants because it has
    effectively received competitive bids for projects, made reasonable
    decisions, and tracked grant funds well.

    Department of Education: Pell Grants:

    Expenditures:

    * 2005: $1.83 million;
    * 2006: $2.19 million.

    Recipient: Palau Community College through individual students:

    Purpose and legislation: Pell Grants, from the Department of Education,
    are intended to provide eligible, undergraduate students with financial
    assistance for educational expenses. The Higher Education Act of 1965,
    as amended (Pub. L. No. 89-329, 79 Stat. 1219), authorized Palau's
    participation.[Footnote 99] Palau's continued eligibility for Pell
    grants after 2009 is contingent on the continued authorization of
    Palau's eligibility for the program in the reauthorization of the
    Higher Education Act.

    Program observations: The Pell Grant program provides grants to
    eligible Palauan students, and, because of the low-income levels in
    Palau relative to the United States, most students qualify for the
    program. According to a representative from the community college, the
    Pell Grant program provides a valuable source of student aid and
    assists approximately 550 of the 600 students attending the community
    college. This amounts to a cost of approximately $3,987 per student
    receiving Pell Grant assistance.

    Department of Health and Human Services: Head Start:

    Expenditures:
    * 2005: $1.95 million;
    * 2006: $1.88 million.

    Recipient: Palau Community Action Agency:

    Purpose and legislation: The Head Start program is designed to provide
    comprehensive child development services to economically disadvantaged
    children and families. The program promotes school readiness by
    assisting low-income children, ages 3-5, with education, health,
    nutrition, medical, and dental services. Omnibus Budget Reconciliation
    Act of 1981, Pub. L. No. 97-35, � 636, 95 Stat. 499.

    Program observations: Children are eligible to participate in the Head
    Start program based on several criteria, including income levels.
    According to Palau's Head Start representatives, approximately 95
    percent of Palau households qualify by falling under the income level
    threshold, which uses U.S.-based federal income guidelines. The Head
    Start program plays a unique role in Palau's education system as the
    primary pre-school and kindergarten option for most of the nation's
    children. According to government of Palau statistics, approximately 82
    percent of Palau's children enrolled in a pre-school or kindergarten
    are Head Start participants. Palau Head Start maintains 13 educational
    centers located in different areas throughout the country and has a
    funded enrollment level of 509 students, or approximately $3,697 per
    attending child. HHS provides approximately 80 percent of the funding
    for the program and the remaining 20 percent is provided through
    matching funds by the government of Palau or contributed as in-kind
    donations, such as free use of public facilities and parent volunteer
    hours.

    Department of Education: Special Education Grants to States:

    Expenditures:

    * 2005: $0.95 million;
    * 2006: $1.08 million.

    Recipient: Government of Palau, Ministry of Education:

    Purpose and legislation: The Special Education Grants to States is
    provided to local education agencies to help provide special education
    and related services needed to make a free, appropriate public
    education available to children with disabilities. The Individuals with
    Disabilities Education Act (IDEA), Pub. L. No. 91-230, � 611, as added
    by Pub. L. No. 108-446, � 101, 118 Stat. 2662 (2004) codified at 20
    U.S.C. � 1411.

    Program observations: The special education program in Palau is managed
    through Palau's Ministry of Education. According to Ministry of
    Education officials, the U.S. Department of Education is the sole
    source of funding for the special education program. The special
    education program is entirely funded through two grants: The Special
    Education Grant to States (Part B) and the Special Education Program
    for Pacific Island Entities (SEPPIE). The Special Education Grant to
    States program provides funding for daily operating expenses while
    SEPPIE funds are used for renovating special education classrooms and
    educating special education teachers. According to Department of
    Education officials, SEPPIE funds are being phased out and future funds
    will be provided under the Part B grant program.

    Palau's Ministry of Education has used the funding to establish a
    special education program that serves 193 children, at a cost of
    approximately $5,618 per student, either part time or full time, in
    Palau's 16 elementary schools and one high school. In addition, the
    Ministry of Education has established a memorandum of understanding
    with the local Head Start program in order to identify and serve
    students with disabilities who have not yet entered the formal school
    system.

    Department of Health and Human Services: Consolidated Health Centers:

    Expenditures:

    * 2005: $0.56 million;
    * 2006: $0.62 million.

    Recipient: Government of Palau, Ministry of Health:

    Purpose and legislation: The Consolidated Health Center Program
    promotes the development and operation of community-based primary
    health care service systems in medically underserved areas and improves
    the health status of medically underserved populations. This is a
    competitive, grant-based program. Public Health Service Act, Section
    330(e),(g),(h),(i), as added by Health Centers Consolidation Act of
    1996, Pub. L. No. 104-299, � 2, 110 Stat. 3626, 3626-42.

    Program observations: The Consolidated Health Center Program plays a
    supporting role in Palau's public health system. The grant originally
    supported 10 small dispensaries located throughout Palau, although
    several of the dispensaries have been consolidated to create four
    "Super Dispensaries" while still maintaining some of the small
    dispensaries on the outlying islands. During calendar year 2006, over
    18,600 patients received services through the grant-supported health
    clinics.

    Both U.S. agency officials and officials from the government of Palau
    report that the Consolidated Health Centers Program is important for
    Palau. However, a U.S. agency official stated that the program had two
    weaknesses in its implementation. First, the distinction between the
    health center and the national hospital was not clear. The officials
    found it difficult to tell which patients were being treated by which
    organization. Second, the officials said some of the dispensaries
    outside of Koror were inadequate to meet patients' needs in these areas.

    Department of Education: Freely Associated States Education Grants:

    Expenditures:

    * 2005: $0.57 million;
    * 2006: $0.55 million.

    Recipient: Government of Palau, Ministry of Education:

    Purpose and legislation: The Freely Associated States Education Grant
    (FASEG)[Footnote 100]Program is a competitive direct grant program,
    provided by the Department of Education, to local education agencies in
    Palau and other outlying areas (American Samoa, Guam, the Commonwealth
    of the Northern Marianas Islands) as authorized under the Elementary
    and Secondary Education Act of 1965, Pub. L. No. 89-10, � 1121(b) and
    (c), as added by No Child Left Behind Act of 2001, Pub. L. No. 107-110,
    � 101, 115 Stat. 1425, 1513 (2002) codified at 20 U.S.C. � 6331. The
    grant can be used for teacher training, curriculum development,
    instructional materials, general school improvement or reform, and
    direct educational services. In commenting on this report, Department
    of Education officials noted that Palau's continued eligibility for
    FASEG funds will depend on the outcome of the compact review in 2009.
    Under the definition of an outlying area in the No Child Left Behind
    Act, Palau continues to be eligible for the FASEG program until an
    agreement for the extension of the United States education assistance
    under the Compact of Free Association for each of the freely associated
    states becomes effective after the date of the enactment of the No
    Child Left Behind Act of 2001. (20 U.S.C. � 7801 (30)).

    Program observations: The FASEG program assists Palau in addressing a
    challenge that was identified by both the U.S. agency officials and
    officials from Palau's Ministry of Education: improving teacher
    quality. According to officials in Palau's ministry, teacher
    qualifications have been decreasing in recent years because of
    mandatory retirement laws that have caused a number of older, qualified
    teachers to retire. FASEG funds address this issue by allowing
    teachers, administrators, and staff to receive training in content
    selection, standards and benchmarks development, teaching strategies,
    educational technology, and other reading and teacher quality programs.
    In 2006, for example, FASEG program funds were used to sponsor a range
    of educational events and trainings, including a Social Studies Test
    Items Development Workshop and a Writing and Reading Workshop.

    U.S. Department of Agriculture: Rural Utilities Services
    Telecommunications Loan Program:

    Loan Amount: $39.14 million, 4.59 percent interest rate;
    Loan Approved: 1992;
    Loan Due: 2029.

    Recipient: Palau National Communications Corporation (PNCC):

    Purpose and legislation: The Rural Electrification Act of 1936, May 20,
    1936, c. 432, 49 Stat. 1363, as amended, authorized the Secretary of
    USDA to make loans for furnishing and improving telephone service in
    rural areas. The loans were intended to be used to furnish, improve,
    expand, construct, and operate telephone service in rural areas. USDA
    Rural Utilities Service made the loan to PNCC.

    Program observations: PNCC, a semi-autonomous, governmental agency,
    took out a loan for approximately $39 million in 1992 in an effort to
    improve its telecommunications infrastructure. The loan is set at a
    4.59 percent interest rate and will be paid in full on November 30,
    2029. According to PNCC representatives, the funds were used to lay
    fiber-optic cable throughout Palau and construct an outside switch
    board and switch center. According to U.S. agency officials, the loan
    was secured through a government guarantee and through an established
    escrow fund for 1 year's debt payments. U.S. officials stated that PNCC
    is current on its debt and the outstanding loan balance is
    approximately $31 million.

    Both U.S. agency officials and PNCC representatives expressed concern
    regarding PNCC's ability to repay its loan due to increased competition
    in Palau. These officials stated that PNCC is required by law to
    provide universal fixed-line service throughout Palau, and has used the
    revenue generated through its cellular, Internet, and other services to
    support the costs of providing universal fixed-line coverage. According
    to PNCC representatives, outside companies, which are not required to
    offer universal fixed-line service, have entered Palau's cellular and
    long-distance markets, which has reduced PNCC's ability to generate
    revenue. U.S. agency officials and PNCC representatives stated that
    PNCC's ability to repay its loan would be in jeopardy if it continues
    to lose valuable cellular and long-distance customers while maintaining
    expensive universal fixed-line coverage.

    Department of Defense Civic Action Teams:

    Expenditures:

    * 2005: $2.5 million;
    * 2006: $2.3 million.

    Purpose and legislation: The compact's implementing legislation,
    Compact of Free Association with Palau, Pub. L. No. 99-658, 100 Stat.
    3672 (1986), states that "in recognition of the special development
    needs of Palau," the United States "shall make available" military
    Civic Action Teams for use in Palau under terms and conditions mutually
    agreed upon by the United States and Palau. An end date for the CATs is
    not stated.

    Program observations: The CAT program provides assistance to Palau
    through teams of U.S. military service men and women that carry out
    small-scale infrastructure projects and other projects that support
    socioeconomic development and capacity building. CATs have been active
    in Palau for nearly 40 years. Teams of 13 service men and women,
    primarily engineers, are stationed in Palau for 6-month rotations. The
    teams provide assistance in four main areas: (1) community
    construction, (2) apprentice training, (3) community relations, and (4)
    a medical program. Under the community construction program, the CAT
    members complete small-scale infrastructure projects such as renovating
    community centers, maintaining roads, and building basketball courts.
    Members of the local population--frequently Palau's state governments-
    -request specific projects and pay for the raw materials. DOD officials
    stated that occasionally DOD purchased the raw materials because of the
    difficulty in securing funding from the project's sponsor in Palau. In
    2007, CATs in Palau did community construction projects across Palau;
    the projects had a presence in each of Palau's 16 states. While
    conducting these projects, the CATs work with local trainees in an
    apprentice program. These trainees learn construction and mechanic
    trades; others learn administrative or medical skills. CAT members
    assist apprentices with job placement at the end of the program. CAT
    members host community events such as movie nights and tutoring in the
    local schools. Finally, the CAT team offers a free medical clinic to
    the entire community, plus medical outreach to outlying states. DOD
    officials in both Palau and Guam, where operational support is
    conducted, reported that the CATs give U.S. military men and women the
    opportunity to do humanitarian work in a welcoming, positive
    environment. They said the teams are highly visible in Palau and are
    viewed positively by the local population.

    Table 13: Discretionary Federal Program Funds Expended in Palau, 2006:

    U.S. Agency: DOT-FAA;
    Federal Program: Airport Improvement Program;
    2006 Expenditure: $9,400,475;
    Palau Recipient: Palau National Government.

    U.S. Agency: DOT-FAA;
    Federal Program: Total 2006 Program Expenditures;
    2006 Expenditure: $9,400,475.

    U.S. Agency: HHS;
    Federal Program: Head Start;
    2006 Expenditure: $1,881,677;
    Palau Recipient: Palau Community Action Agency.

    U.S. Agency: HHS;
    Federal Program: Centers for Disease Control and Prevention--
    Investigations and Technical Assistance;
    2006 Expenditure: $1,484,325;
    Palau Recipient: Palau National Government.

    U.S. Agency: HHS;
    Federal Program: Consolidated Health Centers;
    2006 Expenditure: $618,157;
    Palau Recipient: Palau National Government.

    U.S. Agency: HHS;
    Federal Program: Substance Abuse and Mental Health Services--Projects
    of Regional and National Significance;
    2006 Expenditure: $309,518;
    Palau Recipient: Palau National Government.

    U.S. Agency: HHS;
    Federal Program: National Bioterrorism Hospital Preparedness Program;
    2006 Expenditure: $301,596;
    Palau Recipient: Palau National Government.

    U.S. Agency: HHS;
    Federal Program: Maternal and Child Health Federal Consolidated
    Programs;
    2006 Expenditure: $269,298;
    Palau Recipient: Palau National Government.

    U.S. Agency: HHS;
    Federal Program: Epidemiologic Research Studies of Acquired
    Immunodeficiency Syndrome (AIDS) and Human Immunodeficiency Virus (HIV)
    Infection in Selected Population Groups;
    2006 Expenditure: $207,265;
    Palau Recipient: Palau National Government.

    U.S. Agency: HHS;
    Federal Program: Basic/Core Area Health and Education Center;
    2006 Expenditure: $198,255;
    Palau Recipient: Palau Community College.

    U.S. Agency: HHS;
    Federal Program: Maternal and Child Health Services Block Grant to the
    States;
    2006 Expenditure: $197,092;
    Palau Recipient: Palau National Government.

    U.S. Agency: HHS;
    Federal Program: Family Planning Services;
    2006 Expenditure: $140,969;
    Palau Recipient: Palau National Government.

    U.S. Agency: HHS;
    Federal Program: Block Grants for Prevention and Treatment of Substance
    Abuse;
    2006 Expenditure: $106,452;
    Palau Recipient: Palau National Government.

    U.S. Agency: HHS;
    Federal Program: Cooperative Agreements to Support Comprehensive School
    Health Programs to Prevent the Spread of HIV and Other Important Health
    Problems;
    2006 Expenditure: $101,734;
    Palau Recipient: Palau National Government.

    U.S. Agency: HHS;
    Federal Program: Project Grants and Cooperative Agreements for
    Tuberculosis Control Program;
    2006 Expenditure: $99,112;
    Palau Recipient: Palau National Government.

    U.S. Agency: HHS;
    Federal Program: Universal Newborn Hearing Screening;
    2006 Expenditure: $80,257;
    Palau Recipient: Palau National Government.

    U.S. Agency: HHS;
    Federal Program: Immunization Grants;
    2006 Expenditure: $77,287;
    Palau Recipient: Palau National Government.

    U.S. Agency: HHS;
    Federal Program: Consolidated Knowledge Development and Application
    Program;
    2006 Expenditure: $76,466;
    Palau Recipient: Palau National Government.

    U.S. Agency: HHS;
    Federal Program: Cooperative Agreements for State-based Diabetes
    Control Programs and Evaluation and Surveillance Systems;
    2006 Expenditure: $67,858;
    Palau Recipient: Palau National Government.

    U.S. Agency: HHS;
    Federal Program: HIV Care Formula Grants;
    2006 Expenditure: $64,628;
    Palau Recipient: Palau National Government.

    U.S. Agency: HHS;
    Federal Program: Block Grants for Community Mental Health Services;
    2006 Expenditure: $50,355;
    Palau Recipient: Palau National Government.

    U.S. Agency: HHS;
    Federal Program: Preventive Health Services--Sexually Transmitted
    Disease Control Grants;
    2006 Expenditure: $30,737;
    Palau Recipient: Palau National Government.

    U.S. Agency: HHS;
    Federal Program: Preventive Health and Health Services Block Grant;
    2006 Expenditure: $22,684;
    Palau Recipient: Palau National Government.

    U.S. Agency: HHS;
    Federal Program: Human Immunodeficiency Virus (HIV)/Acquired
    Immunodeficiency Virus Syndrome (AIDS) Surveillance;
    2006 Expenditure: $17,790;
    Palau Recipient: Palau National Government.

    U.S. Agency: HHS;
    Federal Program: Civil Rights and Privacy Rule Compliance Activities;
    2006 Expenditure: $11,004;
    Palau Recipient: Palau National Government.

    U.S. Agency: HHS;
    Federal Program: Injury Prevention and Control Research and State and
    Community Based Programs;
    2006 Expenditure: $2,500;
    Palau Recipient: Palau National Government.

    U.S. Agency: HHS;
    Federal Program: Total 2006 Program Expenditures;
    2006 Expenditure: $6,417,016.

    U.S. Agency: Education;
    Federal Program: Pell Grant;
    2006 Expenditure: $2,193,038;
    Palau Recipient: Palau Community College.

    U.S. Agency: Education;
    Federal Program: Special Education Grants to States;
    2006 Expenditure: $899,881;
    Palau Recipient: Palau National Government.

    U.S. Agency: Education;
    Federal Program: Freely Associated States Education Grant Program;
    2006 Expenditure: $549,401;
    Palau Recipient: Palau National Government.

    U.S. Agency: Education;
    Federal Program: Upward Bound Program;
    2006 Expenditure: $359,618;
    Palau Recipient: Palau Community College.

    U.S. Agency: Education;
    Federal Program: Upward Bound Math and Science Program;
    2006 Expenditure: $207,487;
    Palau Recipient: Palau Community College.

    U.S. Agency: Education;
    Federal Program: Talent Search;
    2006 Expenditure: $203,054;
    Palau Recipient: Palau Community College.

    U.S. Agency: Education;
    Federal Program: Special Education Grants to States;
    2006 Expenditure: $184,386;
    Palau Recipient: Palau National Government.

    U.S. Agency: Education;
    Federal Program: Student Support Services Program;
    2006 Expenditure: $182,819;
    Palau Recipient: Palau Community College.

    U.S. Agency: Education;
    Federal Program: Gaining Early Awareness and Readiness for
    Undergraduate Programs;
    2006 Expenditure: $171,833;
    Palau Recipient: Palau National Government.

    U.S. Agency: Education; Federal Program: Vocational Education Basic
    Grants to States;
    2006 Expenditure: $153,304;
    Palau Recipient: Palau National Government.

    U.S. Agency: Education;
    Federal Program: Teacher Quality Enhancement Grants;
    2006 Expenditure: $103,527;
    Palau Recipient: Palau National Government.

    U.S. Agency: Education;
    Federal Program: Federal Work Study;
    2006 Expenditure: $90,439;
    Palau Recipient: Palau Community College.

    U.S. Agency: Education;
    Federal Program: Minority Science;
    2006 Expenditure: $87,899;
    Palau Recipient: Palau Community College.

    U.S. Agency: Education;
    Federal Program: Supplemental Educational Opportunity Grant;
    2006 Expenditure: $73,231;
    Palau Recipient: Palau Community College.

    U.S. Agency: Education;
    Federal Program: Vocational Education Occupational and Employment
    Information State Grants;
    2006 Expenditure: $53,241;
    Palau Recipient: Palau National Government.

    U.S. Agency: Education;
    Federal Program: Adult Education State Grant Program;
    2006 Expenditure: $53,105;
    Palau Recipient: Palau National Government.

    U.S. Agency: Education;
    Federal Program: Byrd Honors Scholarships;
    2006 Expenditure: $9,000;
    Palau Recipient: Palau National Government.

    U.S. Agency: Education; Federal Program:
    Total 2006 Program Expenditures;
    2006 Expenditure: $5,575,263.

    U.S. Agency: Interior;
    Federal Program: Economic, Social, and Political Development of the
    Territories[A];
    2006 Expenditure: $2,152,320;
    Palau Recipient: Palau National Government.

    U.S. Agency: Interior;
    Federal Program: Total 2006 Program Expenditures;
    2006 Expenditure: $2,152,320.

    U.S. Agency: Labor;
    Federal Program: Workforce Investment Act Dislocated Workers Program;
    2006 Expenditure: $159,027;
    Palau Recipient: Palau National Government.

    U.S. Agency: Labor;
    Federal Program: Workforce Investment Act Youth Activities;
    2006 Expenditure: $110,150;
    Palau Recipient: Palau National Government.

    U.S. Agency: Labor;
    Federal Program: Workforce Investment Act Adult Program;
    2006 Expenditure: $84,400;
    Palau Recipient: Palau National Government.

    U.S. Agency: Labor;
    Federal Program: Total 2006 Program Expenditures;
    2006 Expenditure: $353,577.

    U.S. Agency: Commerce;
    Federal Program: Special Oceanic and Atmospheric Projects;
    2006 Expenditure: $282,528;
    Palau Recipient: Palau National Government.

    U.S. Agency: Commerce;
    Federal Program: Unallied Management Projects;
    2006 Expenditure: $42,333;
    Palau Recipient: Palau National Government.

    U.S. Agency: Commerce;
    Federal Program: National Oceanic and Atmospheric Administration
    Donation to IRC Meeting;
    2006 Expenditure: $24,300;
    Palau Recipient: Palau National Government.

    U.S. Agency: Commerce;
    Federal Program: Total 2006 Program Expenditures;
    2006 Expenditure: $349,161.

    U.S. Agency: USDA;
    Federal Program: Cooperative Forestry Assistance;
    2006 Expenditure: $171,757;
    Palau Recipient: Palau National Government.

    U.S. Agency: USDA;
    Federal Program: Community Facilities Loans and Grants;
    2006 Expenditure: $70,619;
    Palau Recipient: Palau National Government.

    U.S. Agency: USDA;
    Federal Program: U.S. Department of Agriculture;
    2006 Expenditure: $6,610;
    Palau Recipient: Palau Community College.

    U.S. Agency: USDA;
    Federal Program: Total 2006 Program Expenditures;
    2006 Expenditure: $248,986.

    U.S. Agency: Energy;
    Federal Program: State Energy Program;
    2006 Expenditure: $423;
    Palau Recipient: Palau National Government.

    U.S. Agency: Energy;
    Federal Program: Total 2006 Program Expenditures;
    2006 Expenditure: $423.

    U.S. Agency: All Agencies;
    Federal Program: Total 2006 Program Expenditures;
    2006 Expenditure: $24,497,221.

    Source: Palau national government, Palau Community College, and Palau
    Community Action Agency single audit reports for 2006.

    [A] Interior's programs titled "Economic, Social, and Political
    Development of the Territories" were summed and presented as a single
    program in this table. This number does not include compact direct
    assistance or compact road funding provided by Interior to the
    government of Palau.

    [End of table]

    [End of section]

    Appendix VII: Compact Assistance Provided by the Department of the
    Interior:

    The following table was taken from the Department of the Interior's
    Office of Insular Affairs budget justification for 2009. It provides
    details on the yearly estimated payments by Interior to Palau over the
    first 15 years of the compact. As illustrated by the table, more than
    half of the compact direct assistance was provided in the first three
    years of the compact. The table also includes information on the
    compact road funding.

    Table 16: Compact Assistance Provided by the Department of the
    Interior, Estimated Payments, 1995-2009 (Dollars in thousands):

    Activity (P.L. 99-658): Sect. 211(a) Current Account;
    Fiscal Year 1995: $12,000;
    Fiscal Year 1996: $12,000;
    Fiscal Year 1997: $12,000;
    Fiscal Year 1998: $12,000;
    Fiscal Year 1999: $7,000;
    Fiscal Year 2000: $7,000;
    Fiscal Year 2001: $7,000;
    Fiscal Year 2002: $7,000;
    Fiscal Year 2003: $7,000;
    Fiscal Year 2004: $7,000;
    Fiscal Year 2005: $6,000;
    Fiscal Year 2006: $6,000;
    Fiscal Year 2007: $6,000;
    Fiscal Year 2008: $6,000;
    Fiscal Year 2009: $6,000;
    Totals: $120,000.

    Activity (P.L. 99-658): Sect. 211(b) Energy Production;
    Fiscal Year 1995: $28,000;
    Fiscal Year 1996: [Empty];
    Fiscal Year 1997: [Empty];
    Fiscal Year 1998: [Empty];
    Fiscal Year 1999: [Empty];
    Fiscal Year 2000: [Empty];
    Fiscal Year 2001: [Empty];
    Fiscal Year 2002: [Empty];
    Fiscal Year 2003: [Empty];
    Fiscal Year 2004: [Empty];
    Fiscal Year 2005: [Empty];
    Fiscal Year 2006: [Empty];
    Fiscal Year 2007: [Empty];
    Fiscal Year 2008: [Empty];
    Fiscal Year 2009: [Empty];
    Totals: $28,000.

    Activity (P.L. 99-658): Sect. 211(c) Communications;
    Fiscal Year 1995: $1,650;
    Fiscal Year 1996: $150;
    Fiscal Year 1997: $150;
    Fiscal Year 1998: $150;
    Fiscal Year 1999: $150;
    Fiscal Year 2000: $150;
    Fiscal Year 2001: $150;
    Fiscal Year 2002: $150;
    Fiscal Year 2003: $150;
    Fiscal Year 2004: $150;
    Fiscal Year 2005: $150;
    Fiscal Year 2006: $150;
    Fiscal Year 2007: $150;
    Fiscal Year 2008: $150;
    Fiscal Year 2009: $150;
    Totals: $3,750.

    Activity (P.L. 99-658): Sect. 211(d) Maritime Surveillance, Health,
    Scholarships;
    Fiscal Year 1995: $631;
    Fiscal Year 1996: $631;
    Fiscal Year 1997: $631;
    Fiscal Year 1998: $631;
    Fiscal Year 1999: $631;
    Fiscal Year 2000: $631;
    Fiscal Year 2001: $631;
    Fiscal Year 2002: $631;
    Fiscal Year 2003: $631;
    Fiscal Year 2004: $631;
    Fiscal Year 2005: $631;
    Fiscal Year 2006: $631;
    Fiscal Year 2007: $631;
    Fiscal Year 2008: $631;
    Fiscal Year 2009: $631;
    Totals: $9,465.

    Activity (P.L. 99-658): Sect. 211(e) Start-up for 211(d);
    Fiscal Year 1995: $667;
    Fiscal Year 1996: [Empty];
    Fiscal Year 1997: [Empty];
    Fiscal Year 1998: [Empty];
    Fiscal Year 1999: [Empty];
    Fiscal Year 2000: [Empty];
    Fiscal Year 2001: [Empty];
    Fiscal Year 2002: [Empty];
    Fiscal Year 2003: [Empty];
    Fiscal Year 2004: [Empty];
    Fiscal Year 2005: [Empty];
    Fiscal Year 2006: [Empty];
    Fiscal Year 2007: [Empty];
    Fiscal Year 2008: [Empty];
    Fiscal Year 2009: [Empty];
    Totals: $667.

    Activity (P.L. 99-658): Sect. 211(f) Investment Fund[A];
    Fiscal Year 1995: $66,000;
    Fiscal Year 1996: [Empty];
    Fiscal Year 1997: $4,000;
    Fiscal Year 1998: [Empty];
    Fiscal Year 1999: [Empty];
    Fiscal Year 2000: [Empty];
    Fiscal Year 2001: [Empty];
    Fiscal Year 2002: [Empty];
    Fiscal Year 2003: [Empty];
    Fiscal Year 2004: [Empty];
    Fiscal Year 2005: [Empty];
    Fiscal Year 2006: [Empty];
    Fiscal Year 2007: [Empty];
    Fiscal Year 2008: [Empty];
    Fiscal Year 2009: [Empty];
    Totals: $70,000.

    Activity (P.L. 99-658): Subtotal Sec. 211:
    Fiscal Year 1995: $108,948;
    Fiscal Year 1996: $12,781;
    Fiscal Year 1997: $16,781;
    Fiscal Year 1998: $12,781;
    Fiscal Year 1999: $7,781;
    Fiscal Year 2000: $7,781;
    Fiscal Year 2001: $7,781;
    Fiscal Year 2002: $7,781;
    Fiscal Year 2003: $7,781;
    Fiscal Year 2004: $7,781;
    Fiscal Year 2005: $6,781;
    Fiscal Year 2006: $6,781;
    Fiscal Year 2007: $6,781;
    Fiscal Year 2008: $6,781;
    Fiscal Year 2009: $6,781;
    Totals: $231,882.

    Activity (P.L. 99-658): Sect. 212(b) Capital Account;
    Fiscal Year 1995: $36,000;
    Fiscal Year 1996: [Empty];
    Fiscal Year 1997: [Empty];
    Fiscal Year 1998: [Empty];
    Fiscal Year 1999: [Empty];
    Fiscal Year 2000: [Empty];
    Fiscal Year 2001: [Empty];
    Fiscal Year 2002: [Empty];
    Fiscal Year 2003: [Empty];
    Fiscal Year 2004: [Empty];
    Fiscal Year 2005: [Empty];
    Fiscal Year 2006: [Empty];
    Fiscal Year 2007: [Empty];
    Fiscal Year 2008: [Empty];
    Fiscal Year 2009: [Empty];
    Totals: $36,000.

    Activity (P.L. 99-658): Sect. 213 Defense Use Impact;
    Fiscal Year 1995: $5,500;
    Fiscal Year 1996: [Empty];
    Fiscal Year 1997: [Empty];
    Fiscal Year 1998: [Empty];
    Fiscal Year 1999: [Empty];
    Fiscal Year 2000: [Empty];
    Fiscal Year 2001: [Empty];
    Fiscal Year 2002: [Empty];
    Fiscal Year 2003: [Empty];
    Fiscal Year 2004: [Empty];
    Fiscal Year 2005: [Empty];
    Fiscal Year 2006: [Empty];
    Fiscal Year 2007: [Empty];
    Fiscal Year 2008: [Empty];
    Fiscal Year 2009: [Empty];
    Totals: $5,500.

    Activity (P.L. 99-658): Sect. 215 Inflation Adjustment;
    Fiscal Year 1995: $35,719;
    Fiscal Year 1996: $5,842;
    Fiscal Year 1997: $6,075;
    Fiscal Year 1998: $6,440;
    Fiscal Year 1999: $3,790;
    Fiscal Year 2000: $3,861;
    Fiscal Year 2001: $4,004;
    Fiscal Year 2002: $4,147;
    Fiscal Year 2003: $4,147;
    Fiscal Year 2004: $4,290;
    Fiscal Year 2005: $3,752;
    Fiscal Year 2006: $3,936;
    Fiscal Year 2007: $4,121;
    Fiscal Year 2008: $4,305;
    Fiscal Year 2009: $4,490;
    Totals: $98,917.

    Activity (P.L. 99-658): Subtotal;
    Fiscal Year 1995: $186,167;
    Fiscal Year 1996: $18,623;
    Fiscal Year 1997: $22,856;
    Fiscal Year 1998: $19,221;
    Fiscal Year 1999: $11,571;
    Fiscal Year 2000: $11,642;
    Fiscal Year 2001: $11,785;
    Fiscal Year 2002: $11,928;
    Fiscal Year 2003: $11,928;
    Fiscal Year 2004: $12,071;
    Fiscal Year 2005: $10,533;
    Fiscal Year 2006: $10,717;
    Fiscal Year 2007: $10,902;
    Fiscal Year 2008: $11,086;
    Fiscal Year 2009: $11,271;
    Totals: $372,299.

    Activity (P.L. 99-658): Sect. 221(b) Special Block Grant;
    Fiscal Year 1995: $6,300;
    Fiscal Year 1996: $4,900;
    Fiscal Year 1997: $3,500;
    Fiscal Year 1998: $2,000;
    Fiscal Year 1999: $2,000;
    Fiscal Year 2000: $2,000;
    Fiscal Year 2001: $2,000;
    Fiscal Year 2002: $2,000;
    Fiscal Year 2003: $2,000;
    Fiscal Year 2004: $2,000;
    Fiscal Year 2005: $2,000;
    Fiscal Year 2006: $2,000;
    Fiscal Year 2007: $2,000;
    Fiscal Year 2008: $2,000;
    Fiscal Year 2009: $2,000;
    Total: $38,700.

    Activity (P.L. 99-658): Direct payments;
    Fiscal Year 1995: $192,467;
    Fiscal Year 1996: $23,523;
    Fiscal Year 1997: $26,356;
    Fiscal Year 1998: $21,221;
    Fiscal Year 1999: $13,571;
    Fiscal Year 2000: $13,642;
    Fiscal Year 2001: $13,785;
    Fiscal Year 2002: $13,928;
    Fiscal Year 2003: $13,928;
    Fiscal Year 2004: $14,071;
    Fiscal Year 2005: $12,533;
    Fiscal Year 2006: $12,717;
    Fiscal Year 2007: $12,902;
    Fiscal Year 2008: $13,086;
    Fiscal Year 2009: $13,271;
    Total: $410,999.

    Activity (P.L. 99-658): Federal services[B];
    Fiscal Year 1995: $0;
    Fiscal Year 1996: $0;
    Fiscal Year 1997: $0;
    Fiscal Year 1998: $0;
    Fiscal Year 1999: $0;
    Fiscal Year 2000: $0;
    Fiscal Year 2001: $0;
    Fiscal Year 2002: $0;
    Fiscal Year 2003: $0;
    Fiscal Year 2004: $0;
    Fiscal Year 2005: $0;
    Fiscal Year 2006: $0;
    Fiscal Year 2007: $0;
    Fiscal Year 2008: $0;
    Fiscal Year 2009: $0;
    Total: $0.

    Activity (P.L. 99-658): Sect. 212(a) Palau Road Construction;
    Fiscal Year 1995: $53,000;
    Fiscal Year 1996: [Empty];
    Fiscal Year 1997: $96,000;
    Fiscal Year 1998: [Empty];
    Fiscal Year 1999: [Empty];
    Fiscal Year 2000: [Empty];
    Fiscal Year 2001: [Empty];
    Fiscal Year 2002: [Empty];
    Fiscal Year 2003: [Empty];
    Fiscal Year 2004: [Empty];
    Fiscal Year 2005: [Empty];
    Fiscal Year 2006: [Empty];
    Fiscal Year 2007: [Empty];
    Fiscal Year 2008: [Empty];
    Fiscal Year 2009: [Empty];
    Totals: $149,000.

    Activity (P.L. 99-658): Grand total, Palau;
    Fiscal Year 1995: $245,467;
    Fiscal Year 1996: $23,523;
    Fiscal Year 1997: $122,356;
    Fiscal Year 1998: $21,221;
    Fiscal Year 1999: $13,571;
    Fiscal Year 2000: $13,642;
    Fiscal Year 2001: $13,785;
    Fiscal Year 2002: $13,928;
    Fiscal Year 2003: $13,928;
    Fiscal Year 2004: $14,071;
    Fiscal Year 2005: $12,533;
    Fiscal Year 2006: $12,717;
    Fiscal Year 2007: $12,902;
    Fiscal Year 2008: $13,086;
    Fiscal Year 2009: $13,271;
    Total: $559,999.

    Source: Department Of The Interior, Office Of Insular Affairs.

    [A] Palau may withdraw $5 million annually from the fund in years 5
    through 15.

    [B] Aggregate amount included on the FSM/RMI Compact Estimated Amounts
    table for federal services for FSM/RMI/Palau.

    [End of table]

    [End of section]

    Appendix VIII: Comments from the Department of Interior:

    The Associate Deputy Secretary Of The Interior:
    Washington:

    May 28, 2008:

    Mr. David Gootnik:
    Director, International Affairs and Trade:
    United States Government Accountability Office:
    441 G Street, NW:
    Washington D.C. 20548:

    Dear Mr. Gootnik:

    Thank you for the opportunity to review and comment on the draft
    Government Accountability Office Report entitled, "Compact Of Free
    Association. Palau's Use of and Accountability for U S. Assistance and
    Prospects for Economic Self-Sufficiency," (GAO-08-732). The Department
    of the Interior finds the Report very useful as we prepare for the
    required Compact review between the United States and Palau. The Report
    provides key information upon which to discuss future Executive Branch
    policy.

    The Department accepts the recommendation to formally consult with
    Palau regarding Palau's financial management challenges and to assist
    Palau in building financial management capacity. We have already had
    preliminary discussions with our training partner, the U.S. Department
    of Agriculture Graduate School, to implement a program of leadership
    and succession planning for key positions in the island governments. We
    will address Palau's needs specifically as part of the Compact review.

    Thank you again for the opportunity to comment on the Report. If you
    have any questions concerning the response, please communicate with
    Nikolao Pula, Director of the Office of Insular Affairs, at (202) 208-
    4736.

    Sincerely,

    Signed by:

    James E. Cason:

    [End of section]

    Appendix IX: Comments from the Republic of Palau:

    Republic of Palau:
    Office of the President:
    Tommy E. Remengesau, Jr., President:
    P.O. Box 6051, Palau, PW 96940:
    Tel. (680)767-2403/2828:
    Fax. (680)767-2424/1662:
    email-IN:rop.presidemt@palaunet.com:

    May 13, 2008:
    Serial No. 08-117:

    David B. Gootnick:
    Director, International Affairs and Trade:
    U.S. Government Accountability Office:
    441 G Street N.W.
    Washington D.C. 20548:

    Subject: Response to Draft GAO Report No. GAO-08-732:

    Dear Mr. Gootnick:

    Along with appropriate Executive Branch staff, I have reviewed your
    draft GAO Report, dated June 2008, and, on behalf of the President of
    the Republic of Palau, make the comments that follow. I intend to limit
    my comments to issues that are appropriately related to the scope of
    the Daft Report, which included (1) the provision of Compact and other
    U.S. assistance to Palau in 1995-2009, (2) Palau's and U.S. agencies'
    efforts to provide accountability over Palau's use of federal funds in
    1995-2006, and (3) Palau's prospects for achieving economic self-
    sufficiency.

    I. 1995-2009 Compact Assistance:

    In general terms, Palau concurs with the economic analyses and figures
    set forth in the Draft Report. Palau would, however stress that Palau
    entered the Compact period in a position of extreme reliance on United
    States assistance. Total assistance flows in the initial years of the
    Compact were exceptionally high relative to the size of the economy and
    were in excess of 36 percent of GDP and represented roughly 64 percent
    of current expenditures at that time. Since that time, Palau has
    gradually-but persistently-become less reliant. As of Fiscal Year 2007,
    total United States assistance was equal to approximately 16 percent of
    GDP (inclusive of the $5 million drawdown allowed from the Compact
    Trust Fund), and United States assistance represented 41 percent of
    current expenditures.

    II. Accountability:

    In the area of accountability, Palau once again concurs with the
    general findings of the Draft Report. Palau has, indeed, made
    significant progress, as reflected in recent single audit reports. In
    fact, Palau was the first of the insular and FAS governments to achieve
    an unqualified audit opinion of its financial statements; having
    achieved that in Fiscal Year 2003 and in each subsequent year.

    That being said, Palau also recognizes that there are factors related
    to continuing fiscal constraints that hinder our ability to sustain the
    progress that we have made. Despite the fact that the Office of Insular
    Affairs, within the Department of Interior, has provided support to
    Palau's on-going efforts to improve its financial management capacity
    through the PITI/VITI Program (Pacific Islands Training Initiative/
    Virgin Islands Training Initiative) and the FMIP (Financial Management
    Improvement Program), the inability of the Ministry of Finance to
    recruit and maintain qualified personnel associated with ongoing fiscal
    constraints, as well as the non-competitive civil service compensation,
    creates significant challenges for the Republic.

    Palau agrees with the report finding that documentation of required
    annual economic consultations was lacking; however, Palau did benefit
    significantly from nearly annual economic consultations and did take
    those meetings as opportunities to address important economic
    performance and policy matters. Perhaps even more benefit was derived
    from our ongoing, but informal, interactions with lead U.S. government
    officials. In the future, Palau will undertake to take the lead on
    documenting mandated consultations for the record, so that Palau will
    ensure full compliance with current and future Compact requirements.

    Palau also supports the Draft Report's recommendation for the Office of
    Insular Affairs (OIA) to continue to assist Palau in building financial
    management capacity. However, for this assistance to be effective,
    Palau intends to establish an on-going institutional strengthening
    program that focuses on human resource development and improved
    retention of key personnel to insure that financial management
    improvements are sustainable.

    III. Achieving Self Sufficiency:

    Once again, the Republic concurs with the primary findings of the Draft
    Report relating to Palau's prospects for achieving economic self-
    sufficiency. While Palau has made real progress over the last fourteen
    years on overall reliance on U.S. direct and federal funding
    assistance, these funding sources remain a significant and critical
    funding resource to the Republic, particularly for health and education
    program expenditures. Taken together, the loss of direct assistance, as
    partially replaced by annual Trust Fund withdrawals, the potential loss
    of discretionary federal programs and the potential loss of federal
    services (postal, weather and aviation services) would have a dramatic
    negative impact on Palau's efforts to continue to move towards self-
    sufficiency.

    In addition, Palau concurs with the Report's analysis of the Trust Fund
    and its potential depletion after 2016. Combined with the adverse
    impact from the diminishing inflation-adjusted value of the Trust Fund,
    failure to sufficiently capitalize the Trust Fund could lead to dire
    economic consequences.

    Regarding the issue of fiscal reform, Palau recognizes that ultimate
    self-sufficiency can only result from the effective implementation of
    rigorous economic reforms. As part of an overall structural reform
    program, Palau is currently looking to establish a medium-term fiscal
    framework that, assuming a recapitalized Trust Fund, over ten years,
    calls for operational expenditure reductions and domestic revenue
    increases that, together, will result in current expenditures being
    funded primarily from domestic resources.

    Finally, Palau understands that the private sector will need to grow to
    offset and support overall economic growth in the face of necessary
    fiscal adjustments over the medium-to-long term. As employment in
    public administration contracts and as current government expenditures
    decline as a share of GDP, an enhanced private sector policy framework
    will be needed to support private sector expansion. Policy commitments
    in this regard will likely include:

    * Undertaking comprehensive tax reform;
    * Overhauling foreign investment regulations;
    * Reviewing and reforming the legal system for commercial activities;
    * Reforming the financial market;
    * Land reform; and;
    * Articulating and implementing high end tourism policies.

    Palau understands that a number of issues are beyond the scope of your
    report. In particular, Palau would note that there are important
    strategic and economic benefits to the United States from (a) Palau's
    contributions as a strong ally of the United States in security and
    diplomatic matters including the U.S. military service of its youth and
    its strategic location in the Pacific and (b) the significant world
    wide leadership that Palau provides on environmental matters,
    particularly those related to preservation of its maritime treasures.
    The economic costs of these efforts are not directly reflected in
    Palau's economic performance or the scope of the GAO report.

    On behalf of President Tommy E. Remengesau, Jr., I would like to thank
    you and the staff of the GAO for its very thorough analysis of the
    issues relating to Palau presented in your report to the U.S. Congress.
    If you have any further questions regarding these very pressing issues,
    please feel free to present them for our immediate response.

    Sincerely,

    Signed by:
    Billy G. Kuartei:
    Chief of Staff:
    Republic of Palau:

    [End of section]

    Appendix X: GAO Contact and Staff Acknowledgments:

    GAO Contact:

    David Gootnick, 202-512-3149 or gootnickd@gao.gov:

    Staff Acknowledgements:

    In addition to the individual named above, Emil Friberg, Assistant
    Director; Kate Brentzel; Ming Chen; Cheryl Clark; Leslie Locke; Matthew
    Reilly; Kendall Schaefer; and Doris Yanger made key contributions to
    this report. Reid Lowe and Grace Lui provided technical assistance.

    [End of section]

    Footnotes:

    [1] Unless otherwise noted, all years cited are fiscal years (Oct. 1-
    Sept. 30). Because the compact entered into force on Oct. 1, 1994, U.S.
    assistance under the compact began in fiscal year 1995.

    [2] The compact's federal programs and services agreement establishes
    the terms under which the U.S. government provides compact federal
    services--postal, weather, and aviation--to Palau (see Federal Programs
    and Services Agreement Concluded Pursuant to Article II of Title Two
    and Section 232 of the Compact of Free Association). The agreement,
    which took effect in 1995, expires at the end of 2009; unless it is
    renewed or extended, the provision of compact federal services will not
    continue. The agreement sets up the legal status of programs and
    related services, federal agencies, U.S. contractors, and personnel of
    U.S. agencies implementing both compact federal services and
    discretionary federal programs. The agreement does not mandate the
    provision of discretionary programs in Palau. U.S. legislation
    establishes Palau's eligibility for these programs, with funding for
    the programs appropriated by Congress. The impact of the agreement's
    expiration in 2009 on discretionary programs' operation in Palau is
    uncertain. The level of discretionary federal program funding after
    2009 also depends on Palau's program eligibility status and the
    availability of appropriations; changes in either factor may increase
    or reduce the amounts received.

    [3] Agreement Concerning Procedures for the Implementation of United
    States Economic Assistance, Programs and Services Provided in the
    Compact of Free Association Between the Government of the United States
    and the Government of the Republic of Palau.

    [4] The compact required the United States to set up the trust fund
    with an initial investment of $66 million in 1995 and an additional $4
    million in 1997. The compact stated that the trust fund's objective was
    to produce an average annual distribution of $15 million starting in
    2010 for 35 years. It also stated that $5 million shall be distributed
    annually from the fund for Palau's current account operations and
    maintenance, starting in 1999. Under the compact's trust fund
    agreement, Palau, in its management of the fund, agreed to be guided by
    distributions set forth in a table, which set forth goals for the
    minimum and maximum amounts of annual distribution (see Agreement
    Between the Government of the United States and the Government of Palau
    Regarding Economic Assistance Concluded Pursuant to Section 211(f) of
    the Compact of Free Association).

    [5] The National Weather Service is part of the National Oceanic and
    Atmospheric Administration within the Department of Commerce.

    [6] In this report, "compact direct assistance" refers to the grants
    enumerated in sections 211-215 and section 221(b) of the compact. For
    further details, see table 2.

    [7] All dollar amounts in this report are in current (i.e., nominal)
    dollars.

    [8] All trust fund return rates in this report are net of fees and
    commissions, unless otherwise stated.

    [9] In 1994, the United Nations concluded that the United States had
    satisfactorily discharged its obligations as administering authority of
    the Trust Territory of the Pacific Islands.

    [10] After growing strongly in the first few years of the compact,
    Palau's GDP declined in 1999 and stagnated until 2003 due, in part, to
    negative impact on its tourism sector from the 1999 Asian Financial
    Crisis and the September 11, 2001 terrorism attacks. Growth resumed in
    2004. Per capita GDP estimates include both Palauan-born citizens and
    foreign workers.

    [11] This estimate excludes substantial in-kind foreign assistance from
    donors, often for infrastructure projects. Foreign-funded projects
    include the U.S.-funded compact road, the Japanese-funded Friendship
    Bridge connecting Babeldaob to Koror, and the Taiwanese-funded
    agricultural technical mission.

    [12] Data on foreign workers are from Palau's Social Security office
    and exclude workers not registered with the office.

    [13] See Proclamation 6726 Placing into Full Force and Effect the
    Compact of Free Association with the Republic of Palau, 59 Fed. Reg.
    49777 (Sept. 27, 1994).

    [14] The 15-year term is from 1995 to 2009.

    [15] The U.S. government may audit the funds directly or use an
    external public auditor; in either case, the audits are conducted at no
    cost to the government of Palau. The U.S. government's authority to
    audit compact funds continues for at least 3 years after the last
    element of assistance has been provided and expended.

    [16] All nonfederal entities that expend more than a threshold amount
    ($500,000 as of 2004) in federal awards in a year are required to
    obtain an annual audit in accordance with the Single Audit Act,
    codified, as amended at 31 U.S.C. Chp. 75. Single audits are audits of
    the recipient organization--in Palau, the national government and other
    component units--that focus on the recipient's financial statements,
    internal controls, and compliance with laws and regulations governing
    federal grants. One of the objectives of the act is to promote sound
    financial management, including effective internal controls, with
    respect to federal expenditures of the recipient organization. Single
    audit reports include the auditor's opinion on the audited financial
    statements and a report on the internal controls related to financial
    reporting. The single audit reports also include the auditor's opinion
    on compliance with requirements of major federal programs and a report
    on internal controls related to compliance with laws, regulations, and
    the provisions of contracts or grant agreements.

    [17] Office of Management and Budget (OMB) Circular No. A-133, Audits
    of States, Local Governments, and Non-Profit Organizations, establishes
    policies for federal agencies to use in implementing the Single Audit
    Act and provides an administrative foundation for consistent and
    uniform audit requirements for nonfederal entities administering
    federal awards.

    [18] Although all federal awarding agencies are responsible for
    ensuring that single audit reports are completed in accordance with OMB
    Circular No. A-133 and are received in a timely manner, one of the
    award-making agencies--usually the agency that provides the largest
    amount of funding--is designated as the cognizant agency, with specific
    responsibilities under OMB Circular No. A-133. Cognizant agencies'
    additional responsibilities include coordinating management decisions
    for audit findings that affect the audit programs of more than one
    agency and considering auditee requests for extensions to the due dates
    of the reports.

    [19] As a member of Palau's audit resolution team, the Office of the
    Public Auditor is responsible for (a) monitoring each affected agency
    with a single audit finding or questioned cost, (b) performing follow-
    up on corrective actions, and (c) reporting to Interior's OIG regarding
    audit findings and questioned costs that have been effectively
    resolved. The Office of the Public Auditor also is involved in ensuring
    that Palau's component units finalize their audits in time for
    inclusion in Palau's single audit report.

    [20] Other U.S. agencies' discretionary federal grant programs have
    accountability requirements that are specific to those programs. We did
    not assess Palau's compliance with these requirements. However, Palau's
    expenditure of federal grants is included in the single audits; these
    audits review Palau's compliance with federal program requirements.

    [21] According to Executive Order 12569 of 1986, reprinted in 51 Fed.
    Reg. 37171 (Oct. 16, 1986), Interior is responsible for ensuring that
    the economic and financial assistance provided by the compact is made
    available to Palau as well as for monitoring any program or activity
    provided to Palau by all U.S. agencies except DOD; State is responsible
    for government-to-government relations between the United States and
    Palau.

    [22] Palau is required to submit these economic development plans every
    5 years during the duration of title two of the compact.

    [23] Title three of the compact also includes a requirement for
    consultations between the United States and Palau. It requires the U.S.
    and Palau governments to establish a joint committee to discuss any
    disputes over the security and defense provisions of the compact. The
    joint committee is required to meet semiannually unless otherwise
    mutually agreed.

    [24] Some of the financial data presented for discretionary federal
    programs in this report were extracted from Palau's audited financial
    statements for 1995-2006; the statements for 1995-2002 received
    qualified opinions from external auditors. Therefore, these figures are
    subject to the limitations cited by the auditors in their opinions and
    to the material internal control weaknesses identified.

    [25] The compact states that the amounts specified in sections 211-215
    are "backed by the full faith and credit of the United States," which
    legally guarantees funding.

    [26] Palau includes an account of its implementation of direct
    assistance in the compact annual reports it submits to the U.S.
    government.

    [27] Although the compact states that Palau shall receive $2 million
    per year in 211(b) funding, a related agreement--Agreement Concerning
    Special Programs Related to the Entry into Force of the Compact of Free
    Association Between the Government of the United States and the
    Government of the Republic of Palau--specified that the United States
    would fulfill this commitment with a lump sum deposit of $28 million in
    the first year the compact went into effect, i.e. fiscal year 1995,
    plus an inflation adjustment of $12 million. The agreement requires
    Palau to pay $3 million to the United States by September 30, 2005, as
    a net economic cost to the United States for making the $28 million
    available to Palau in the first year of the compact. In its 2005 annual
    report, Palau reported that an official request had been made to
    utilize the $3 million to establish a capital fund for compact road
    maintenance. The U.S. Congress recently passed legislation that permits
    Palau to retain the $3 million to set up a trust fund for compact road
    maintenance, as long as the fund is established and operated pursuant
    to an agreement entered into between the U.S. government and the
    government of Palau. See Pub. L. No. 110-229, Title VIII, Sec. 808, 122
    Stat. 874 (May 8, 2008).

    [28] Section 215 states that the amounts stated in sections 211(a),
    211(b), 211(c), and 212(b) shall be adjusted for each fiscal year by
    the percent which equals two-thirds of the percentage change in the
    United States Gross National Product Implicit Price Deflator, or 7
    percent, whichever is less in any 1 year, using fiscal year 1981 as the
    base.

    [29] These services are provided under section 221 of title two of the
    compact. The United States provides in-kind contributions for the
    postal and aviation services and reimburses the government of Palau for
    the cost of operating its weather station.

    [30] Palau operates its own postal service for internal mail
    distribution, and transports mail to and from air and sea ports for
    international shipment, at which point USPS takes responsibility.

    [31] The federal programs and services agreement states that after the
    effective date of the compact, USPS may establish cost-related rates
    for mail from the United States to Palau. A USPS official said that
    State officials told USPS that raising the rates could have a negative
    effect on the compact's goal of establishing Palau's economic self-
    sufficiency, so USPS kept the postal rates the same as U.S. domestic
    rates.

    [32] USPS relies on contracted commercial air service for airmail
    shipment to Palau.

    [33] FAA provides the following services to Palau: en-route air traffic
    control from the Oakland, California airport, maintenance of
    nondirectional beacon and distance measuring equipment at Palau's
    airport; maintenance of precision approach path indicator lighting
    system and runway end identifier lights at Palau's airport; flight
    inspection of airport navigational aids; development of instrument
    approach and departure procedures; and technical assistance and
    training.

    [34] This figure is based, in part, on information obtained in the
    single audits for 1995 through 2006 for the three primary recipients of
    U.S. federal grants in Palau: the Palau national government, the Palau
    Community College, and the Palau Community Action Agency. At the time
    of this report, audited financial data for 2007 were not yet available.

    [35] The Palau Community College is the only postsecondary school in
    Palau.

    [36] TRIO grant-based programs are educational and opportunity outreach
    programs designed to support students from disadvantaged backgrounds.

    [37] The Upward Bound program, part of the TRIO programs, is designed
    to provide support for participants to succeed in their precollege and
    higher education pursuits.

    [38] According to U.S. agency officials, the Palau Community Action
    Agency has been the sole grantee and Head Start service provider for
    the 40 years the program has existed in Palau.

    [39] With the exception of DOD's CAT program, our analysis did not
    quantify the value of this additional U.S. assistance and it is not
    included in the discretionary federal program total of $266.7 million
    in figure 3 or U.S. agency expenditures in figure 4.

    [40] We did not attempt to estimate the cost of Peace Corps's presence
    in Palau from 1995-2009.

    [41] Our analysis did not attempt to quantify the value of U.S. agency-
    provided development loans, and this value is not included in the
    discretionary federal program total of $266.7 million in figure 3 or
    U.S. agency expenditures in figure 4.

    [42] Under the Single Audit Act, the single audit reporting package is
    generally required to be submitted to the Federal Audit Clearinghouse,
    which is an automated database of single audit information, either 30
    days after the receipt of the auditor's report or 9 months after the
    end of the period under audit.

    [43] At the time of this report, Palau's fiscal year 2007 single audit
    report had not been submitted and is not due for submission until June
    30, 2008.

    [44] Auditors are required by the Single Audit Act and OMB Circular No.
    A-133 to provide an opinion (or disclaimers of opinion, as appropriate)
    as to whether financial statements are presented fairly in all material
    respects in conformity with generally accepted accounting principles.
    Generally accepted accounting principles are the conventions, rules,
    and procedures that provide the norm for fair presentation of financial
    statements. Auditors render a qualified opinion when they identify one
    or more specific matters that affect the fair presentation of the
    financial statements. The effect of the auditors' qualified opinion can
    be significant enough to reduce the usefulness and reliability of the
    financial statements.

    [45] Sound internal control over financial reporting is needed to
    adequately safeguard assets; ensure that transactions are properly
    recorded; and prevent or detect fraud, waste, and abuse.

    [46] The 2006 single audit report cited five material weaknesses and
    nine reportable conditions in internal control over financial
    reporting. Reportable conditions are related to significant
    deficiencies in the design or operation of internal controls that could
    adversely affect the audited entity's ability to produce financial
    statements that fairly represent the entity's financial condition.
    Material weaknesses are reportable conditions in which the design or
    operation of internal controls does not reduce to a relatively low
    level the risk that misstatements caused by error or fraud--material in
    relation to the financial statements being audited--may occur and not
    be detected in a timely period by employees in the normal course of
    performing their duties. The material weaknesses cited in the 2006
    report included (1) lack of supporting documentation to support travel
    expenditures; (2) lack of review of monthly bank reconciliations and
    nonresolution of reconciling differences; (3) lack of policies and
    procedures to reconcile accounts receivable and prepayments; and (4)
    lack of adherence to prescribed travel policies and procedures.

    [47] In addition to requiring auditors to assess financial statements,
    the Single Audit Act and OMB Circular No. A-133 require auditors to
    determine and express an opinion as to whether the auditee has complied
    with laws, regulations, and the provisions of contracts or grant
    agreements that may have a direct and material effect on each of its
    major federal programs. Auditors are to identify the applicable
    compliance requirements to be tested and reported on in a single audit.
    OMB's Compliance Supplement lists and describes the types of compliance
    requirements and related audit objectives and suggested audit
    procedures that auditors should consider in single audits conducted in
    accordance with OMB Circular No. A-133. When auditors identify
    instances of noncompliance, they are required to report whether the
    noncompliance could have a direct and material effect on a major
    federal program.

    [48] Of the internal control weaknesses reported in 2006, 15 were
    reportable conditions and 1 was considered material. In the context of
    compliance, reportable conditions are matters that come to an auditor's
    attention related to significant deficiencies in the design or
    operation of internal controls over compliance that could adversely
    affect the entity's ability to operate a major federal program within
    the applicable requirements of laws, regulations, contracts, and
    grants. Material weaknesses in this context are reportable conditions
    in which internal controls do not reduce to a relatively low level the
    risk of noncompliance with applicable requirements of laws,
    regulations, contracts, and grants that would be material to the major
    federal program being audited and undetected in a timely way by
    employees in the normal course of performing their duties.

    [49] The 2006 report stated that this particular weakness is caused by
    a decentralized, fixed asset accounting division that appears to be
    disassociated from the rest of the accounting function, resulting in a
    process with little coordination, review, and monitoring.

    [50] According to the 2006 single audit report, Palau's plans to
    address the report's findings about its compliance with, and internal
    control over compliance with, federal program requirements also include
    reconciling, reporting, and resolving differences related to its
    federal grants receivable balances with federal grantor agencies;
    ensuring that expenditures charged to federal programs are directly
    related to program goals and objectives; strengthening internal
    controls over program budget documentation, to ensure budgeted
    allotments agree with program objectives; and improving compliance with
    period of federal grant availability requirements.

    [51] DOD officials also reported, and provided documentation of, annual
    meetings between DOD and the government of Palau to discuss security
    and defense issues pertinent to title three of the compact. The DOD
    officials said that the U.S. and Palau governments had agreed to hold
    the meetings annually, instead of semiannually as required by the
    compact and that recent meetings were held in Palau, Guam, and Hawaii.

    [52] Palau's domestic revenues include taxes, fees and charges,
    licenses, permits, and other direct revenues. In-kind foreign
    assistance, net investments--equal to the net change in the fair value
    of investments minus investment management fees--and other net
    financing are excluded due to market volatility associated with
    investment earnings and the prominent role in net financing of the
    compact-provided trust fund, which was designed to provide Palau with
    financing only until 2044.

    [53] FAA's Airport Improvement Program grant to Palau represented more
    than $9 million of this assistance in 2006; it expired in 2007. The
    Airport Improvement Program's reauthorization for 2008-2011 is
    currently pending before Congress. It contains language that would
    continue Palau's eligibility for this program.

    [54] IMF projected in 2006 the return required for the Palau trust fund
    to last until 2044 to be 10.4 percent. It assumed the disbursement is
    inflation adjusted while GAO's projection is based on the disbursement
    not being inflation adjusted.

    [55] To calculate the compounded returns, we used the annual nominal
    returns published in IBBOTSON Associates 2008 Yearbook. We rebalance
    the portfolio annually to maintain the asset allocation of 50 percent
    in U.S. large capital funds, 15 percent in U.S. small capital funds,
    and 35 percent in fixed income assets. See table 12 in appendix IV for
    the nominal and real returns of various time periods.

    [56] Without market volatility, an 8.6 percent return rate would allow
    the trust fund to grow in perpetuity, as shown in figure 6.

    [57] Compact section 215 states "the amounts stated in Sections 211(a),
    211(b), 211(c) and 212(b) shall be adjusted for each fiscal year by the
    percent which equals two-thirds of the percentage change in the United
    States Gross National Product Implicit Price Deflator, or seven
    percent, whichever is less in any one year, using the beginning of
    fiscal year 1981 as the base." The annual distributions from the trust
    fund are not subject to section 215.

    [58] We used the inflation rate projected by the Congressional Budget
    Office, which is lower than the historical inflation rate (from 1970 to
    2007). A higher inflation rate will lead to further decline in value.

    [59] See IMF, Republic of Palau: 2005 Article IV Consultation - Staff
    Report (Washington, D.C., March 2006). [hyperlink,
    http://www.imf.org/external/pubs/cat/longres.cfm?sk=19023.0] (accessed
    May 27, 2008). The IMF's analysis of Palau's fiscal sustainability
    prospects recognizes that Palau will undergo a period of adjustment
    after compact direct assistance expires at the end of 2009 while
    pursuing economic reforms they suggest for implementation over a 10-to
    15-year period.

    [60] Absent market volatility, we estimate that the trust fund will
    likely grow in perpetuity if either the fund's compounded return rate
    or the asset classes' historical compounded return rate continues.
    Nonetheless, the IMF reports that Palau should decrease its dependence
    on the trust fund for annual financing. As a small island economy,
    Palau is vulnerable to external shocks, including damaging weather-
    related events, and trust fund assets could be reserved in order to
    enhance Palau's resiliency to such challenges.

    [61] For example, a 2000 planning document prepared by the Japan
    International Cooperation Agency cites the need to reduce public sector
    employment by 40 percent between fiscal years 1999 and 2009, freeze
    public sector wages, privatize public sector enterprises, implement tax
    reform, and introduce vehicle-related taxes. Palau's Cost Reduction
    Plan of 2002 cites the need for government personnel restructuring,
    outsourcing services, and strengthening tax collection efforts.

    [62] Although many noncompliant businesses may be smaller in size, the
    30 largest taxpayers in Palau are estimated to provide 88 percent of
    tax revenues.

    [63] This settlement of $1.25 million represents the outstanding
    principal of $645,000 plus 50 percent ($606,000) of the interest due of
    $1.2 million. The settlement excludes in full the $4 million of
    assessed penalties. Payments are to be made at a rate of not less than
    $10,000 per month, with the remaining balance accruing interest at a
    rate of 9 percent. Several Palau officials indicated concern with the
    terms of this settlement because the former President of Palau served
    as a representative for the foreign-owned company.

    [64] In addition to rising wage costs, government officials expressed
    concern about the financial soundness of the Civil Service Pension
    Fund. A 2005 actuarial valuation found that assets were sufficient to
    cover only 50 percent of liabilities. As such, the fund must draw on
    its investments to meet current obligations, which expanded in the late
    1990s when state and college employees, who had not fully contributed
    to the plan, were added as beneficiaries.

    [65] Economic research on the impact of road investments suggests a
    variety of possible benefits, including reduced transport costs,
    lowered input prices, increased access to markets, new migration
    opportunities, and improved information flow. The IMF finds
    infrastructure investment to be a statistically significant factor for
    increasing tourism expenditure in island economies. Palau officials
    reported that two hotels, a supermarket, and a port are planned for
    construction around the road. Despite potential benefits, Palau
    officials also expressed concern about environmental costs, including
    the introduction of invasive species from a reduction in the tree
    canopy, increased sediment run off, and watershed management problems.

    [66] Tourist expenditure varies significantly by nationality. The ADB
    estimates the economic benefit from a U.S. tourist is about $900 per
    visit compared with about $150 per visit for a Taiwanese tourist. Many
    visitors from Taiwan travel on vouchers, where a large share of the
    money is paid to the travel agent rather than in country.

    [67] Palau's tourism, agriculture, and fisheries sector are highly
    dependent on the environment and vulnerable to climate change. About 25
    percent of Palau's landmass is less than 10 meters above sea level. El
    Ni�o events affect Palau significantly on a regular basis through
    decreased rainfall and increased sea water temperatures. Such events in
    1997 and 1998 reportedly destroyed one-third of Palau's coral reefs,
    millions of its unique jellyfish, and most of its taro crops. See
    Palau's First National Communication to the United National Framework
    Convention on Climate Change, 2002.

    [68] In 1997, a group of bank supervisors from advanced countries--the
    Basel Committee on Banking Supervision--issued the Core Principles for
    Effective Bank Supervision that provided best practices for financial
    regulation in developing countries. Since 1999, the IMF and World Bank
    have assessed member country compliance with the Basel principles. In
    2002, the IMF assessed Palau's financial system as noncompliant on 16
    of 25 Basel principles and reports improvements have not yet been made.
    The Financial Institutions Commission is working with the Palau
    Congress to revamp banking laws to be Basel compliant and is pursuing
    strengthened regulations.

    [69] The Pacific Savings Bank, which held 20 percent of deposits in
    Palau, went into receivership in November 2006 due to inadequate
    capital and nonperforming insider loans. The ADB and Financial
    Institutions Commission attribute the bank failure to weak bank
    regulation. Potential costs to the government include the $1.4 million
    deposit of the national government, the $2.1 million deposit of the
    Palau Public Utilities Corporation, and the $1.5 million deposit of the
    Civil Service Pension Fund.

    [70] Late payments by the government also have been a challenge for the
    Palau Public Utilities Corporation, which had a net loss of $6.6
    million in 2005 and 2006. According to government officials, other
    factors contributing to this net loss include the cost of providing
    universal service under a fixed fee structure and an inability to raise
    rates quickly when oil prices rise.

    [71] Unless otherwise noted, all years cited are fiscal years (Oct. 1-
    Sept. 30).

    [72] At the time of this report, Palau's fiscal year 2007 single audit
    report had not been submitted and was not due for submission until June
    30, 2008.

    [73] The FAC operates on behalf of the Office of Management and Budget
    (OMB) and its primary purposes are to disseminate audit information to
    federal agencies and the public, support OMB oversight and assessment
    of federal award audit requirements, assist federal cognizant and
    oversight agencies in obtaining OMB Circular No. A-133 data and
    reporting packages, and, to help auditors and auditees minimize the
    reporting burden of complying with OMB Circular No. A-133 audit
    requirements.

    [74] Compact of Free Association Act of 1985, Pub. L. No. 99-239, 99
    Stat. 1770 (1986).

    [75] Compact of Free Association with Micronesia and Marshall Island,
    Pub. L. No. 108-188, 117 Stat. 2720 (2003).

      [76] For an in-depth discussion of the renegotiated FSM and RMI
    compacts, see GAO, Compact of Free Association: An Assessment of the
    Amended Compacts and Related Agreements, [hyperlink,
    http://www.gao.gov/cgi-bin/getrpt?GAO-03-890T] (Washington, D.C.: Jun.
    18, 2003).

    [77] Annual grant funding is reduced each year in order to encourage
    budgetary self-reliance and transition the countries from receiving
    annual U.S. grant funding to receiving annual trust fund earnings.
    Additional funds were provided related to the U.S. military use of
    Kwajalein Atoll.

    [78] Palau government officials told us that there is no fixed schedule
    for disbursement and disbursement can happen throughout the year. In
    our simulation, we assume four equal quarterly disbursements at the end
    of each quarter each year.

    [79] Compact section 215 states "the amounts stated in Sections 211(a),
    211(b), 211(c) and 212(b) shall be adjusted for each fiscal year by the
    percent which equals two-thirds of the percentage change in the United
    States Gross National Product Implicit Price Deflator, or seven
    percent, whichever is less in any one year, using the beginning of
    Fiscal Year 1981 as the base." The annual distributions from the trust
    fund are not subject to section 215.

    [80] The project is currently the subject of a construction contract
    dispute and the final U.S. cost of the project cannot be determined
    until the dispute is resolved.

    [81] The compact road was designed and constructed to the same
    standards as noninterstate roads in the United States and included two
    12-foot-wide asphalt paved lanes, designed to carry 400 to 2,500
    vehicles per day, at speeds of up to 35 miles per hour, a pavement
    design life of 20 years, and a bridge design life of 100 years,
    providing they receive proper maintenance. The lower traffic volumes
    were used in the design of the road spur at the north end of the
    compact road and the highest volumes were used between the airport and
    Palau's capitol. The project also was designed and constructed to meet
    U.S. environmental laws and included the U.S. Fish and Wildlife
    Service, the National Marine Fisheries Service, and the U.S.
    Environmental Protection Agency as partners in the project.

    [82] Maintenance requirements were set out in the subsidiary
    construction projects agreement known as Agreement Regarding
    Construction Projects in Palau Concluded Pursuant to Section 212(a) of
    the Compact of Free Association.

    [83] USACE officials served as the project and program manager under an
    agreement with the Department of the Interior, in which USACE agreed to
    provide program and project management services, such as design
    management, contract procurement, and construction management.

    [84] The term "double bituminous" was not defined in the compact,
    however, USACE interpreted the term to mean a two-layer application of
    asphalt and stone chips similar to what is typically identified as
    "chip and seal" and is found on many rural roads in the United States.

    [85] Road specifications were set out in Annex A of the subsidiary
    construction projects agreement.

    [86] Pub. L. No. 104-134, 110 Stat. 1321, 1321-174 (1996).

    [87] Because the project was limited to 53 miles, the entire ring was
    not constructed by the United States and is currently being completed
    by Taiwan.

    [88] Construction required cutting and filling several million cubic
    yards of earth, building seven bridges, and installing 20 box culverts
    and 372 culverts. The construction employed over 1,100 workers
    representing 10 different nationalities and required more than 500
    pieces of heavy equipment at the peak of construction.

    [89] Cut slope failures on the compact road are landslides that
    resulted directly from road construction activities that cut into
    hillsides.

    [90] Expenses and budget data reported for the compact road are based
    on information received in interviews and have not been independently
    verified.

    [91] Reported by USACE officials as of December 31, 2007.

    [92] Daewoo Eng'g and Constr. Co., LTD v. United States, 73 Fed.Cl. 547
    (2006) (notice of appeal filed on June 19, 2007).

    [93] Examples of such emergencies are tropical storms and vehicle
    accidents.

    [94] Crack sealing is a process of cleaning out cracks in the pavement
    and filling them with sealant to prevent water from getting under the
    pavement causing it to deteriorate.

    [95] The Palau Bureau of Public Works includes several organizational
    divisions such as the Division of Facilities and Maintenance, Division
    of Road and Equipment, and Division of Utilities. The Division of Road
    and Equipment is further divided into branches including the Bridge and
    Road Maintenance Branch, which is responsible for maintaining the
    compact road.

    [96] The decision to purchase a particular piece of equipment should
    include a justification process that considers all alternatives to
    accomplishing a task, including leasing, renting from other agencies or
    contractors, adapting an existing piece of equipment to perform the
    needed task, or contracting out the entire project. A piece of
    equipment may not be economically viable if not used sufficiently.

    [97] See Pub. L. No. 110-229, Title VIII, Sec. 808, 122 Stat. 874 (May
    8, 2008).

    [98] See H.R. 2881, 110th Cong. (2007).

    [99] 20 U.S.C. � 1091.

    [100] While the formal title of the program is "Territories and Freely
    Associated States Education Grant," it is also known as the Freely
    Associated States Education Grant.

    [End of section]

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