China in Transition

The Illusion that Long Holidays Help Boost the Economy
The lessons to be learned from the Laffer curve

Chi Hung KWAN
Consulting Fellow, RIETI

China has just celebrated the Lunar New Year. China now has three long holidays every year, including the Lunar New Year, and is on a par with industrialized nations in terms of the number of holidays per year. The government hopes that long holidays would help expand domestic demand and thus boost the economy. However, when we note how they affect the supply side, it is obvious that the resulting cut in working hours is detrimental to the Chinese economy. To my surprise, when I wrote an essay along this line in the Sept. 26 edition of the China Business Times last year, right before the National Day holidays, many readers were not convinced. Some argue that if workers are given more time to rest, productivity would rise so that output would actually increase. This logic is similar to that of the Laffer curve, which formed the theoretical foundation for the tax cuts implemented by the administration of U.S. President Ronald Reagan in the early 1980s. It also harbors the same danger of misleading policymakers.

When drawn on a diagram, the Laffer curve takes the shape of an inverted U-shaped curve that links tax revenue to different tax rates ( diagram 1 ). Thus, up to a certain point, tax revenue increases if the tax rate is raised, but beyond that point, people lose the incentive to work hard because much of their income would be collected as tax. As a result, output and income would fall, and tax revenue would in fact decrease. In the worst case, if the tax rate is 100 percent, no one would bother to work and tax revenue would fall to zero. As this shows, in a situation where tax rates are so high as to be on the right side of the Laffer curve, it is theoretically possible to increase tax revenue by reducing the tax rate.

Diagram 1: The Laffer curve

Diagram 1 The Laffer curve

The relationship between working hours and output can also be explained using a similar curve ( diagram 2 ). Output increases up to certain level if the number of working hours is increased. However, once beyond that point, productivity falls due to overwork, and total output is likely to fall as people work longer hours. As an extreme example, if they die of overwork, output falls to zero.

Therefore, the effect of shorter working hours on productivity is different depending on whether the country in question is situated on the left or right side of the curve. In the case of the former, reducing working hours leads to a fall in output, but in the case of the latter, output would grow. In China's case, as it is a nation that already gives its people many days off, as can be seen in its introduction of the five-day workweek, it is natural to believe that it is on the left, rather than right, side of the curve. As such, shortening working hours through long holidays means that output, and thus income, would decrease, and it is questionable whether this really boosts demand. Even if demand were to grow, individual households would either have to withdraw their savings or borrow money to pay for their expenses.

Diagram 2:The relationship between working hours and output

Diagram 2 The relationship between working hours and output

In the first half of the 1980s, the Reagan administration implemented tax cuts, mistakenly thinking that the relationship between tax rates and tax revenue in the U.S. at the time placed it on the right side of the Laffer curve. As a result, contrary to its intentions, tax revenue fell sharply, leading to a sharp rise in the country's fiscal deficit, high interest rates and an accumulation of external debt. As this experience shows, policies based on mistaken judgments can be very costly. China is still a developing country, and it is true that there is room to greatly boost productivity if it makes good use of the advantage of being a latecomer. However, this goal can be achieved only by strengthening the supply side through such measures as investment in education, infrastructure and research and development, not by shortening working hours. The unrealistic view that rewards can be reaped without toil should be abandoned.

February 7, 2003

February 7, 2003