Compact of Free Association: U.S. Assistance to Palau,		 
Accountability Over Assistance Provided, and Palau's Prospects	 
For Economic Self-Sufficiency (12-JUN-08, GAO-08-858T). 	 
                                                                 
Since 1995, when the Compact of Free Association between Palau	 
and the United States entered into force, U.S. aid to Palau has  
included assistance provided for in the compact and related	 
subsidiary agreements--direct assistance to the Palau national	 
government, including investment in a trust fund intended to	 
provide $15 million annually from 2010 through 2044; federal	 
postal, weather, and aviation services; and construction of a	 
major road--with the U.S. interest of promoting Palau's 	 
self-sufficiency and economic advancement. U.S. assistance to	 
Palau has also included discretionary federal programs, such as  
health, education, and infrastructure services, that are not	 
provided for in the compact. Compact direct assistance is	 
scheduled to expire on September 30, 2009. In addition, the	 
related subsidiary agreement providing for federal services to	 
Palau will expire on that date unless renewed or extended. At	 
that time, Palau's annual withdrawals from its trust fund can	 
increase from $5 million to $15 million. The compact mandates	 
that the U.S. and Palau governments review the terms of the	 
compact and its related agreements in 2009 and concur on any	 
modifications to those terms. 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. To provide	 
accountability for compact funds, the compact's related 	 
agreements require an annual audit of Palau's use of compact	 
funds and require Palau to submit economic development plans,	 
identifying planned expenditures of compact assistance, and	 
annual reports on, among other topics, its implementation of	 
these plans. The U.S. and Palau governments are also required to 
hold annual economic consultations to review Palau's progress	 
toward self-sufficiency and to consult regarding Palau's trust	 
fund every 5 years. My statement is based on our report, which	 
was released this week. In this report, we examined (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, and (3) Palau's
prospects for achieving economic self-sufficiency. 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.						 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-08-858T					        
    ACCNO:   A82342						        
  TITLE:     Compact of Free Association: U.S. Assistance to Palau,   
Accountability Over Assistance Provided, and Palau's Prospects	 
For Economic Self-Sufficiency					 
     DATE:   06/12/2008 
  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				 
	     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-08-858T

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Testimony: 

Before the House Committee on Natural Resources, Insular Affairs 
Subcommittee U.S. House of Representatives: 

United States Government Accountability Office:
GAO: 

For Release on Delivery: 
Expected at 11:00 a.m. EDT:
Thursday, June 12, 2008: 

Compact Of Free Association: 

U.S. Assistance to Palau, Accountability Over Assistance Provided, and 
Palau's Prospects For Economic Self-Sufficiency: 

Statement of David Gootnick: 
Director: International Affairs and Trade Team: 

GAO-08-858T: 

June 12, 2008: 

Madame Chairwoman and Members of the Subcommittee: 

I am pleased to be here today to discuss compact and other U.S. 
assistance to the Republic of Palau. Since 1995,[Footnote 1] when the 
Compact of Free Association between Palau and the United States entered 
into force, U.S. aid to Palau has included assistance provided for in 
the compact and related subsidiary agreements--direct assistance to the 
Palau national government, including investment in a trust fund 
intended to provide $15 million annually from 2010 through 2044; 
federal postal, weather, and aviation services; and construction of a 
major road--with the U.S. interest of promoting Palau's self- 
sufficiency and economic advancement. U.S. assistance to Palau has also 
included discretionary federal programs, such as health, education, and 
infrastructure services, that are not provided for in the compact. 
[Footnote 2] 

Compact direct assistance is scheduled to expire on September 30, 2009. 
In addition, the related subsidiary agreement providing for federal 
services to Palau will expire on that date unless renewed or extended. 
[Footnote 3] At that time, Palau's annual withdrawals from its trust 
fund can increase from $5 million to $15 million. The compact mandates 
that the U.S. and Palau governments review the terms of the compact and 
its related agreements in 2009 and concur on any modifications to those 
terms. (See attachment I for more information on key provisions of the 
compact and its related agreements.) 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. 

To provide accountability for compact funds, the compact's related 
agreements require an annual audit of Palau's use of compact funds and 
require Palau to submit economic development plans, identifying planned 
expenditures of compact assistance, and annual reports on, among other 
topics, its implementation of these plans. The U.S. and Palau 
governments are also required to hold annual economic consultations to 
review Palau's progress toward self-sufficiency and to consult 
regarding Palau's trust fund every 5 years. 

My statement is based on our report, which was released this week. 
[Footnote 4] In this report, we examined (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, and (3) Palau's prospects for achieving economic self-
sufficiency. 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. 

Summary: 

U.S. aid to Palau in 1995-2009 is expected to exceed $852 million. 
Compact direct assistance, providing general budgetary support for 
Palau's government operations, is projected at $411 million, or 48 
percent of the assistance provided.[Footnote 5] The provision of 
compact federal services--postal, weather, and aviation--is projected 
at about $25 million, or 3 percent of the assistance, and the compact 
road construction accounted for $149 million, or 17 percent of the 
assistance. Palau's receipt of discretionary federal program assistance 
is projected at $267 million, or 31 percent of the total assistance 
provided. In 1995-2006, five U.S. agencies--the Departments of 
Education (Education), Health and Human Services (HHS), Interior, 
Defense (DOD), and Transportation (DOT)--contributed the majority of 
discretionary federal program assistance to Palau. 

Palau has made progress in establishing financial accountability, 
despite limited capacity to address persistent internal control 
weaknesses, and has met most compact accountability requirements; 
however, Interior's monitoring of Palau's accountability has been 
limited. Palau's single audit reports for 1995-2006 show that it 
improved its timeliness in submitting the reports and improved the 
reliability of its financial statements. However, 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 controls over compliance with these requirements. 
Although Palau has developed plans to correct these weaknesses, limited 
capacity in financial accounting resources and expertise puts at risk 
Palau's ability 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 required economic consultations 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 has used Palau's single audit results and compact 
annual reports to monitor Palau's use of compact funds and has provided 
technical assistance funds to train Palau employees as well as funds to 
enhance Palau's financial management systems and processes. However, 
OIA officials said that Interior 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 projected 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 6] 
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, 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 increase its tax income by addressing the problem of weak 
tax administration and reduce its expenditures by 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, our report 
recommends that the Secretary of the Interior direct OIA 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. Responding to a draft 
of our report, Interior agreed with our recommendation and identified 
steps it will take to implement it. 

Background: 

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. Roughly 20,000 
people live in Palau, and more than one-quarter of the population is 
non-Palauan. 

Palau's economy is heavily dependent on its tourism sector and on 
foreign aid from the United States, Japan, and Taiwan. Since 1994, 
Palau's economy has grown at a real annual average of 3 percent. 
[Footnote 7] In 2006, Palau's gross domestic product (GDP) was about 
$154 million and its GDP per capita was about $7,500. 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 approximately 
$89 million, equivalent to 58 percent of its GDP, and the United States 
and other donors provided grants totaling about $44 million, equivalent 
to 28 percent of Palau's GDP (see attachment II). Palau's national 
government employed about one-third of all workers in 2006, and the 
government's wage bill constituted 37 percent of its total 
expenditures.[Footnote 8] The national government's 2006 expenditures 
exceeded its total revenues; however, Palau has access to financing 
through interest earned on government assets and to annual withdrawals 
on the compact-provided trust fund. Palau's private sector relies 
heavily on foreign workers, mostly from the Philippines; since 1994, 
foreign workers have grown to account for half of Palau's total labor 
force.[Footnote 9] 

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

The United States' cost of providing assistance to Palau in 1995-2009 
is projected to exceed $852 million. The three categories of assistance 
mandated by the compact--compact direct assistance, compact federal 
services, and compact road construction--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. 
(See attachment III.) 

* 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. This assistance flows as a direct 
transfer payment to the government of Palau. The compact specifies 
general purposes for these funds--for example, current account 
operations and maintenance, energy production self-sufficiency, 
maritime zone surveillance and enforcement, and initial funding of the 
trust fund--but gives the Palau government broad discretion regarding 
their use.[Footnote 10] Some direct assistance is provided annually for 
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, allowing Palau to invest some of these 
funds to generate additional income. All compact direct assistance will 
terminate in 2009. (See attachment IV.) 

* 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. In 1995- 
2009, U.S. agencies provided compact federal services at a total cost 
of approximately $25.3 million: the U.S. Postal Service spent about 
$12.3 million, the National Weather Service spent about $8.6 million, 
and the Federal Aviation Administration spent about $4.4 million. 

* Compact road. The compact required the United States to build a road 
system in Palau, based on specifications mutually agreed upon with the 
government of Palau, which was to be completed by October 1, 2000. The 
road project incurred several planning and construction delays and was 
completed on October 1, 2007, at a cost of approximately $149 million. 
When the road was completed, Palau accepted responsibility for its 
operation and maintenance. Palau has since made efforts to maintain the 
road; however, both U.S. and Palau officials expressed concerns 
regarding Palau's ability to maintain the road in a condition that will 
allow for the desired economic development. 

* Discretionary federal programs. Discretionary federal programs are 
projected to contribute approximately $266.7 million, or almost a third 
of U.S. assistance to Palau in 1995-2009. In 1995-2006, more than 14 
U.S. agencies provided approximately $203 million in federal grants and 
other in-kind services to assist in areas such as education, health, 
infrastructure improvement, and telecommunications.[Footnote 11] Five 
agencies--Education, HHS, Interior, DOD, and DOT--contributed the 
majority of this assistance (see attachment V). Most grants went to the 
Palau national government; the Palau Community College and the Palau 
Community Action Agency, a nonprofit organization, also received 
grants. 

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

Although Palau's more recent single audit reports show improvement in 
its financial accountability, the reports show persistent weaknesses in 
its internal control over financial reporting, its compliance with some 
federal award requirements, and its internal control over compliance 
with these requirements. However, Palau has limited capacity to address 
these weaknesses in a timely way, putting Palau 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 compact assistance 
was limited. 

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, Palau submitted reports for 
2005 and 2006 on time. 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. 

In addition, the recent single audits show that the reliability of 
Palau's financial statements has improved. 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 12] For 2003-2006, Palau's financial statements consistently 
received unqualified audit opinions, indicating that the auditor 
considered the statements reliable. 

However, despite the improved reliability of its financial statements, 
Palau has long-standing and significant weaknesses in its internal 
control over financial reporting and has limited capacity to address 
these weaknesses. 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. Palau has developed corrective action plans to address these 
weaknesses and is also updating its financial reporting policies and 
procedures. 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. As a result, Palau is at 
risk of being unable to sustain its improvements in financial 
accountability. 

Further, Palau has limited capacity to address weaknesses in its 
compliance with federal award requirements. Since 1995, Palau's single 
audit reports have consistently contained 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 13] These weaknesses could adversely affect 
Palau's ability to operate a major federal program within the 
applicable requirements of laws, regulations, contracts, and grants. 
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. However, 
Palau's limited staff and expertise hinder its ability to address the 
single audit report's findings in a timely manner. 

Regarding compliance with the compact and its related agreements, Palau 
met the majority of the reporting requirements, submitting the required 
economic development plans and annual reports. Palau and U.S. officials 
reported holding the required economic consultations but in most cases 
did not document their compliance. However, according to Palau and U.S. 
officials, the required trust fund consultations did not take place. 

Interior provided limited oversight of Palau's accountability for 
compact and other U.S. assistance. Interior's OIA and Office of 
Inspector General (OIG) reported efforts to assist or oversee Palau's 
accountability for federal funds. For example, according to Interior 
officials, Interior 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; and worked with 
Palau to track single audit findings and resolve issues. Also, 
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. However, an OIA 
official said that its oversight of compact funding has not been 
extensive and that the compact gives Palau broad discretion in compact 
spending. Moreover, 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 achieving long-term economic self-sufficiency 
depend on at least four factors: levels of continuing 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. 

Levels of U.S. Assistance: 

Palau's prospects for economic self-sufficiency depend in part on 
levels of continuing discretionary federal program assistance and 
compact federal services. 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 14]--will total about $87 million (see attachment 
VI). 

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. 

Any changes in the levels of discretionary federal program assistance 
and compact federal services after 2009 will affect Palau's fiscal 
condition. Discretionary federal program assistance, which grew from 
$7.3 million in 2000 to $18.8 million in 2006, is projected at $11.3 
million in 2008[Footnote 15] and may total almost $12 million, or 14 
percent of the national government revenues, in 2009. However, the 
level of discretionary program funding after 2009 will depend on 
Palau's program eligibility status and the availability of 
appropriations; changes in either factor may increase or reduce the 
amounts received.[Footnote 16] Absent affirmative action by Congress, 
Palau's eligibility for some federal programs could expire. The 
expiration of the compact's federal programs and services agreement in 
2009 may also impact U.S. agencies' implementation of discretionary 
federal programs in Palau, although agency officials we interviewed 
expressed uncertainty about the extent of any such impact. Moreover, 
unless the federal programs and services agreement is renewed or 
extended past 2009, Palau will lose postal, weather, and aviation 
services that are estimated to cost U.S. agencies almost $1.6 million 
in 2009. 

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. 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 
rate 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 rates 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 17] If the trust fund continues to earn the 9 percent 
annual return it has earned thus far, or any rate equal or greater than 
8.6 percent, the trust fund will likely grow in perpetuity from its 
balance as of March 2008 (see attachment VII). 

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 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, a few consecutive years of poor stock market performance 
could lead to the depletion the fund. Attachment VIII illustrates 
results from our analysis with the assumption that future returns are 
drawn from distributions based on the historical 1970-2007 return 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 exhausted after 2016. 

In addition, inflation will diminish the value of the annual trust fund 
withdrawals: because the withdrawals are not adjusted for inflation, 
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 18] 

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 International Monetary Fund (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 19] 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. Palau could seek continued donor assistance to pay 
for capital expenditures; moreover, 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 expected exhaustion of the trust fund 
after 2044 as well as the risk of its earlier exhaustion due to market 
volatility. 

To close the gap between Palau's revenue and expenditures, 
implementation of tax and expenditure reforms will be needed according 
to economic experts, Palau officials, and the country's economic plans. 
However, full implementation of such reforms is expected to require 10 
to 15 years. 

* Tax revenue. In 2006, Palau's 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, according to IMF and 
Asian Development Bank (ADB) experts, Palau's tax system is inefficient 
because of, among other problems, weak tax administration and 
ineffective tax policy. For example, fewer than 50 percent of active 
taxpayers are fully compliant, according to the IMF and ADB; the 
government rarely collects assessed penalties and interest or exercises 
its authority to suspend or revoke business licenses; and the current 
system does not tax nonwage income, such as that from profits, 
investment, or property, and taxes businesses on gross, rather than 
net, earnings. 

* Expenditures. Economic experts and government officials suggest that 
Palau could lower its operating expenditures, at around $67 million in 
2006, by reducing the public sector wage bill. Although Palau has 
slightly reduced its nonwage operating expenditures since 2000, it has 
been less successful in reducing the wage bill. From 2000 through 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. 

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. 
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 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. 

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. For example, Palau imposes 
stringent requirements on foreign investment, restricting foreign 
investment in certain activities; Palau's financial markets do not 
effectively finance investment but instead supply large amounts of 
consumer credit; Palau's system of land ownership prevents the 
effective use of land for development; available skilled labor is 
lacking in Palau and Palau government officials expressed concern about 
illegal importation of unskilled foreign workers; and Palau's 
commercial legal system is outdated, lacking laws for bankruptcy, 
sales, and consumer privacy protection, and the government often 
reportedly delays payment of vendors for several years. 

Conclusions and Recommendations: 

In 2009, the U.S. and Palau governments will formally review the terms 
of the compact and its related agreements. Although compact direct 
assistance will expire that year, the provision of federal postal, 
weather, and aviation services may continue if the federal programs and 
services agreement is renewed or extended. Some discretionary federal 
programs will also likely continue. Interior's OIA will remain the 
cognizant agency for Palau for compact direct assistance through 2009 
and will continue to review Palau's single audits as long as U.S. 
federal program funds are expended in Palau. However, unless Palau 
strengthens its financial accounting resources and expertise, its 
ability to sustain recent progress in financial accountability and to 
operate a major federal program according to applicable requirements is 
at risk. To strengthen Palau's ability to provide accountability and 
meet applicable requirements for federal assistance, our recent report 
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 to target future 
technical assistance toward building Palau's financial management 
capacity. Interior agreed with our recommendation and identified steps 
it will take to implement it. 

Madame Chairwoman, this completes my prepared statement. I would be 
happy to respond to any questions you or other Members of the 
Subcommittee may have at this time. 

[End of section] 

Attachment I: Key Provisions of the Palau Compact of Free Association 
and Related Agreements: 

Compact section: Title one: Government Relations; 
Description of key provision: 
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 provision: 
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 provision: 
* 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 provision: 
* 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. 

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

[End of table] 

[End of section] 

Attachment II: Palau National Government Expenditures and Revenues, 
2000-2006: 

[See PDF for image] 

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 Palauï¿½s single audit reports. 

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] 

[End of section] 

Attachment III: Projected U.S. Assistance to Palau, 1995-2009: 

[See PDF for image] 

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] 

[End of section] 

Attachment IV: Compact Direct Assistance to Palau, 1995-2009: 

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

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

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

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

Compact section: 215; 
Compact-mandated assistance: 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; 
Compact-mandated assistance: 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. 

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] 

[End of section] 

Attachment V: U.S. Agencies' Expenditures for Discretionary Programs 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] 

[End of section] 

Attachment VI: 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: 

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. See GAO-08-732, appendix III, for 
additional information. 

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. 

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

[End of figure] 

[End of section] 

Attachment VII: Palau's Projected 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] 

[End of section] 

Attachment VIII: 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: 

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. 

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

[End of figure] 

[End of section] 

Attachment IX: GAO Contacts and Acknowledgments: 

GAO Contacts: 

For further information about this statement, please contact David 
Gootnick at (202) 512-3149 or [email protected]. Contact points for our 
Offices of Congressional Relations and Public Affairs may be found on 
the last page of this statement. Staff making key contributions to this 
statement were Emil Friberg, Assistant Director; Kate Brentzel; Ming 
Chen; Cheryl Clark; Leslie Locke; Reid Lowe; Grace Lui; Matthew Reilly; 
Kendall Schaefer; and Doris Yanger. 

[End of section] 

Footnotes: 

[1] Unless otherwise noted, all years cited are fiscal years (Oct. 1- 
Sept. 30). In addition, all dollar amounts in this report are in 
current (i.e., nominal) dollars. 

[2] U.S. legislation establishes Palau's eligibility for these 
programs, with funding for the programs appropriated by Congress. 

[3] The compact's federal programs and services agreement, which 
establishes the terms under which the U.S. government provides federal 
postal, weather, and aviation services to Palau, took effect in 1995 
and expires in 2009 (see Federal Programs and Services Agreement 
Concluded Pursuant to Article II of Title Two and Section 232 of the 
Compact of Free Association). 

[4] GAO, Compact of Free Association: Palau's Use of and Accountability 
for U.S. Assistance and Prospects for Economic Self-Sufficiency, 
[hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-08-732] (Washington, 
D.C.: June 10, 2008). 

[5] In this statement, "compact direct assistance" refers to the grants 
enumerated in sections 211-215 and section 221(b) of the compact. For 
further details about the compact direct assistance, see attachment IV 
of this statement. 

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

[7] 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 terrorist attacks. Growth resumed in 
2004. Per capita GDP estimates include both Palauan-born citizens and 
foreign workers. 

[8] See [hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-08-732] for 
more information on Palau's national government finances. 

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

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

[11] This amount is based, in part, on information obtained in the 
single audits for 1995 through 2006. At the time of this report, 
audited financial data for 2007 were not yet available; Palau's 2007 
single audit report is not due until June 30, 2008. Although this 
amount includes the cost to DOD of providing a Civic Action Team in 
Palau, it does not include the value of other in-kind assistance 
provided by DOD or other U.S. agencies and does not include the value 
of U.S. loans extended to Palau. 

[12] 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. 
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. 

[13] 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. 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. 

[14] 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 owing 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 
financing only until 2044. By 2009, Palau's domestic revenues are 
projected to grow to about $44 million, from approximately $30 million 
in 2000, based on the annual growth rate of 4.4 percent in 2000-2006. 
Other donor assistance is projected to grow to about $18 million by 
2009, from about $6 million in 2000, based on its annual growth rate of 
17.4 percent in 2000-2006. Palau's government will also have access to 
financing through earned interest and annual withdrawals from the U.S. 
trust fund and other government assets. 

[15] The 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. 

[16] U.S. legislation establishes Palau's eligibility for these 
programs, with funding for the programs appropriated by Congress. 

[17] 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. 

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

[19] 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]. 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. 

[End of section] 

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