A solution to skyrocketing CEO pay

September 27, 2013: 5:00 AM ET

For several reasons, the SEC's proposed rule to address the growing CEO-average worker pay gap will not work as intended. Here's an alternative approach.

By Sanjay Sanghoee

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FORTUNE -- Last week, the Securities and Exchange Commission unveiled a proposed rule that will compel U.S. companies to disclose how their top executive's pay compares to that of the average worker. The new rule is in response to growing criticism of runaway compensation at many large public companies, wage stagnation for rank-and-file workers, and the seeming inability of corporate boards to tie CEO paychecks to long-term company performance in an effective way.

In an efficient capitalist model, companies would pay CEOs based on a variety of factors, including quarterly earnings, long-term performance, stock price appreciation, innovation, ROC (Return on Capital), employee satisfaction, and customer retention, among many other things. But in practice, CEO pay is often based on only a few metrics that may dazzle analysts and investors in the short run but may not reflect true business fundamentals or likely future performance.

Given that, the SEC's move might seem like welcome news for shareholder activists, workers rights advocates, and labor unions, but it will do little to alter the status quo on pay.

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The reasons for this are many. For one, large shareholders already have access to this information due to their powerful position, and if they have not objected to a CEO's pay yet, they are unlikely to change their stance; plus smaller shareholders do not necessarily care about executive pay as long as their shares go up in value in the near term. Also, Dodd-Frank's say-on-pay rule, which enables shareholders to challenge oversize paychecks, is non-binding on corporate boards and therefore ineffective. On top of all of this, assessing the long- term implications of business decisions and tying them appropriately to short-term executive pay is complicated, and clawbacks can be tricky to execute. And if that weren't enough, many CEOs have undue influence over their boards -- and their own compensation -- sometimes by serving as chairman as well as CEO.

The SEC has been especially active lately in policing the corporate sector, but the new rule cannot address any of the challenges mentioned above and so is unlikely to make a difference on its own. A more effective idea would be for the government to offer companies an incentive to rationalize CEO compensation, such as a tax credit, and to base that tax credit on the CEO-employee pay ratio.

If a company had a pay ratio of 25:1 and 300 workers total, it would receive (for the sake of argument) the following tax credit: $1,000 (unadjusted tax credit per worker) X 1/25 (inverse pay ratio) X 300 (number of workers) = a total of $12,000

In this example, the lower the pay ratio (or the narrower the gap between the pay of the CEO and average workers), the bigger the tax credit, motivating businesses to be more thoughtful in setting compensation for CEOs as well as junior employees. A side benefit of this formula is that a company would also receive credit for hiring more workers, which is an equally worthwhile goal for our government to pursue at a time of high unemployment.

Of course, funding for a new tax credit is difficult to secure, but the CEO pay ratio itself points to a possible solution.

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Currently, tax loopholes that enable companies to shield money from the IRS by moving it to offshore havens cost the Treasury $150 billion every year. The beneficiaries of these loopholes are major corporations with international operations and the means to pursue esoteric tax strategies, but then these are the same companies with the highest CEO pay ratios (354:1). By closing even a portion of these loopholes, the government could easily and justifiably replace them with a tax credit based on the CEO pay ratio for the 3,687 companies traded publicly in the U.S. on regulated exchanges.

If tax credits can be used to encourage investment and innovation, why should they not be used to promote better corporate governance and more hiring?

Sanjay Sanghoee is a political and business commentator. He has worked at investment banks Lazard Freres and Dresdner Kleinwort Wasserstein. He is the author of two thriller novels, including Killing Wall Street.

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