Everyone knows that health care costs are high. It is also known that people tend to spend
Question:
Everyone knows that health care costs are high. It is also known that people tend to
spend less on health care if they spend their own money, which motivated the creation
of flexible spending accounts FSAs Roughly speaking, an FSA works as follows: i at the start of the year, an employee decides how much she will contribute to her FSA; ii the contribution is taken from pretax dollars, which means the employee does not have to pay payroll taxes on the contribution; iii the employee uses her contribution in the FSA to pay for qualified medical expenses during the year, such as eyeglasses and dental work; iv any money left in the FSA at the end of the year is lost.
Clearly, it can make good sense to use the FSA. But there is a catch. You have to decide
on your contribution amount at the start of the year before you really know all of your
expenses, and if you over contribute, you lose the excess amount.
Professor Buket believes that her medical expenses for the coming year will be $
$ $ $ $ $ $ or $ with equal probabilities.
a At the beginning of the year, how much money should Professor Buket place in the
FSA account if her marginal tax rate is
b What is the expected amount of money in the account which remains unused lost
c What is the expected amount of money which she will pay out of her pocket on top
of the money placed in the account in part a
d What is the expected amount of money saved under the optimal strategy in part a
with respect to the case where Prof Buket does not use the account at all