An employer wishes to provide health care benefits to its workers when they retire. The firm faces a current marginal tax rate of 35% and expects to face this rate in the future. On average, employees face a current tax rate of 31%, which is expected to fall to 20% in retirement. The firm earns 12% pretax in its pension account and 15% pretax from its own operations. The average years until retirement for employees is 20 years. The firm is considering funding the promised retiree health care costs through either a sweetened pension benefit or on a pay-as-you-go approach. Under the pay-as-you-go approach, the benefit to employees will be provided as part of a fringe benefit package that is tax deductible to the employer, and the employees are not taxed on the receipt of the benefit. Which alternative—the sweetened pension benefit or pay-as-you-go approach—is tax preferred?
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