Environmental regulation and innovation: Evidence from China

• A theoretical model is developed to predict how command-and-control environmental regulation affects innovation. • The causal relationship between environmental regulation and innovation is empirically identified. • Environmental regulation exerts significant and negative effect on innovation. • A sharp decline in labor demand, firm entry, and inbound foreign direct investment are the main channels. The relevance of analyzing effects of environmental regulation on innovation cannot be overemphasized. In this paper, we first develop a theoretical model to predict how command-and-control environmental regulation affects innovation, and then we derive its channels. Using the difference-in-difference-in-differences strategy and a comprehensive dataset at city-industry-year level of manufacturing sectors in China, we found that the more stringent environmental regulations that are faced by cities, measured by the reduction targets of chemical oxygen demand (COD) and sulfur dioxide (SO 2 ) during the eleventh Five-Year Plan, are negatively associated with innovation. Thus, the evidence contradicts the Porter Hypothesis. On average, a one standard deviation increase in the reduction targets of COD (SO 2 ) is associated with a 0.023 (0.016) standard deviation decrease in the innovation index. We controlled carefully for various potential confounders, and the results were supported by robustness and falsification checks. There exists an evident heterogeneity effect across regions and industries with different pollution intensities. The channel analysis shows that stricter environmental regulation also accounts for a sharp decline in labor demand, firm entry, and inbound foreign direct investment. Our findings are also robust to alternative measures for innovation and environmental regulation.