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The steady state general equilibrium and welfare consequences of a Medicare buyin program, optional for those aged 55-64, is evaluated in a calibrated life-cycle economy with incomplete markets. Incomplete markets and adverse selection create a potential welfare improving role for health insurance reform. We find that adverse selection eliminates any market for a Medicare buy-in if it is offered as an unsubsidized option to individual private health insurance. The subsidy needed to bring the number of uninsured to less than 5 percent of the target population could be financed by an increase in the labor income tax rate of just 0.03 to 0.18 percent depending on how the program is implemented.

This project has benefited from research support provided by GRIPS, where much of this research was completed while Hansen and Lee were Visiting Scholars. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research. NBER working papers are circulated for discussion and comment purposes. They have not been peerreviewed or been subject to the review by the NBER Board of Directors that accompanies official NBER publications.

Starr-McCluer (1996) documented an empirical finding that the US households covered by health insurance saved more than those without coverage, which is inconsistent with the standard consumption-saving theory. This study provides a structural analysis and suggests that institutional factors, in particular, a social insurance (safety net) system and an employment-based health insurance system, can account for this puzzling finding. A dynamic stochastic general equilibrium model is built that incorporates these two institutions with heterogeneous agents making decisions regarding saving, labor supply and health insurance endogenously when they are young. The model, in which agents save in a precautionary manner, can generate Starr-McCluer's empirical finding and it indicates that the empirical finding is not inconsistent with the standard theory of saving under uncertainty. Counterfactual experiments are performed to provide implications for empirical analyses and illustrate the danger of empirical work without a sound theoretical background. JEL Classification: E21, I38, D52Keywords: Precautionary Savings, Social Insurance, Employment-based Health Insurance. * GRIPS, 7-22-1 Roppongi, Minato-ku Tokyo 106-8677, Japan. Email: minchunghsu@grips.ac.jp. I wish to thank the editor and three anonymous referees for their valuable suggestions and comments on an earlier version of this paper. All errors are solely mine.