Reducing Medical Spending of the Publicly Insured: The Case for a Cash-out Option

Individuals' medical spending has both necessary and discretionary components, which are not, however, separately observable. This paper studies ways to improve upon existing public health insurance policies by using a framework where both the discretionary and necessary components of medical spending are explicitly modeled. First, using a simple theoretical framework, the paper shows that the key to reducing discretionary medical spending is to introduce a trade-off between nonmedical and medical consumption. Next, using a rich quantitative life-cycle model, the paper shows that this trade-off can be successfully implemented by introducing an option to substitute public health insurance with cash transfers.