This is not a trivial question. Employers could simply offer an equivalent amount of unpaid leave, providing an option to employees who prefer to take time off while rewarding workaholics for continuing to contribute value to the company. Why doesn't this happen? As far as I can tell, there are four plausible stories:
- Per-hour productivity declines when stressed employees don't take any vacations. In an ideal world, this might be written directly into the contract ("if you work 52 weeks a year, you only get paid 50% for the 52nd week"), but for various reasons that isn't possible, and the second-best solution is to provide paid vacation.
- Paid vacation resolves a bad signaling equilibrium, where everyone feels obligated to put in full hours to signal that they are hard-working and deserve advancement in the company. Offering paid time off convinces enough people to take vacations to break this equilibrium, making virtually everybody happier and better off. (Of course, this could also make the signaling problem worse. How do you signal that you're really hard-working and really devoted to your employer? By not taking paid leave!)
- Paid leave makes leisure time more enjoyable, since you're not incessantly bothered by the fact that you're losing money by being away from work. Employees are willing to sacrifice wages and flexibility for this psychological comfort.
- By encouraging every employee to be away from work for a brief period each year, paid leave allows a "dry run" to see how the workplace might function without that person, ensuring that it's not overdependent on the contributions of a single individual. This reduces the risk from employee attrition and diminishes the bargaining power of workers who might otherwise claim they were indispensable.
Of course, signaling acts as a powerful force against paid leave as well. Suppose that two otherwise identical companies, A and Z, differ in their vacation policy: company A offers higher wages but no paid vacation, while Z has slightly lower salaries and paid leave. In general, who will choose to work at company Z instead of A? People who like to take time off! To the extent that this is correlated with general laziness (not easily detectable in other ways at the hiring stage), it will make company Z's labor pool less effective, discouraging it from offering paid leave in the first place.