The Iraqi government is "dysfunctional" and has failed to meet 11 of 18 key benchmarks set by the US, according to a non-partisan Congressional watchdog.
Political progress in Iraq has been unsatisfactory and violence "remains high", a report by the Government Accountability Office (GAO) found.
Iraq has met three benchmarks and partially met another four, it says.
The report came as the most senior US commander in Iraq suggested that he may recommend a reduction in troops.
Meanwhile President George W Bush strongly defended his policy in Iraq.
Speaking in Sydney after a meeting with the Australian Prime Minister John Howard, Mr Bush said: "The security situation is changing, so that reconciliation can take place."
He added that the fact that Iraqi legislature passed 60 pieces of legislation "was illustrative of a government that's beginning to work".
The set of 18 political and military goals for Iraq were set by Congress, which asked the GAO to inquire whether they had been met.
Its report issued on Tuesday said Iraq had failed to live up to key targets on reducing sectarian violence and passing laws on oil revenue sharing.
It says militias are still active and the performance of the US-backed Iraqi government has been poor.
"Significant progress has not been made in improving the living conditions of the Iraqis on a day-to-day basis with regard to things that all citizens care about - safe streets, clean water, reliable electricity, a variety of other basic things," GAO head David Walker said.
"The government is dysfunctional," he added.
The GAO findings come a day after President George W Bush visited Iraq's Anbar province and said his security surge - the injection of an extra 30,000 troops into Iraq - was delivering results.
The report is the first in a series of assessments over the next month on the situation in Iraq and the success of the US troop surge.
Gen Petraeus will report on the security surge next week
The most crucial findings could be the verdicts of General David Petraeus, the commander of US forces in Iraq, and Ryan Crocker, the US ambassador to Iraq.
They will deliver a full progress report to Congress next week.
The BBC's Justin Webb in Washington says opponents of war will question the purpose of the surge, if the Iraqis themselves cannot use the breathing space provided by US forces to find long-term solutions.
Meanwhile, General Petraeus has suggested he may recommend a reduction in US troop numbers in Iraq.
In an interview with the US television network ABC, he said there were limits to what the military could do.
The GAO assessment contrasts with a White House study in July which found eight of the key US goals had been fully met.
But Tuesday's report was slightly more upbeat than leaks had suggested last week, following criticism from the Pentagon.
The draft report said three benchmarks had been met and only two benchmarks partially met.
Following leaks to the media, a Pentagon spokesman said officials had made some "factual corrections" and "offered some suggestions".