The impact of environmental regulation on total factor productivity of firms: An analysis based on technical distance

Most studies on environmental policy and total factor productivity (TFP) growth under the heterogeneity framework tend to ignore the distance to the technical frontier, while research that investigates TFP growth based on technical distances does not tend to consider environmental policy. To fill this research gap, this study investigates the impact of environmental regulation on the total factor productivity of heterogeneous firms, based on technical distance. In addition to theoretical analysis, we apply a two-direction fixed effects model to test the impact using firm-level data selected from the CSMAR database and environmental regulation data of 287 Chinese cities between 2007 and 2015. We report two major findings from our analysis. First, environmental regulation increasingly enhances (or hinders) TFP growth, as firms get closer to (or further away from) the country-industry technology frontier, ceteris paribus. Second, grouped regression further highlights that environmental regulation affects TFP growth for heterogeneous firms. For proximal-type firms, environmental regulation promotes the growth of TFP through innovation and imitation mechanisms, while only the imitation mechanism works for middle-type firms. Neither mechanism, however, applies to distal-type firms, for whom environmental regulation hinders TFP growth. These conclusions provide a theoretical and practical basis for environmental policy, suggesting that the focus should be directed toward improving exit mechanisms for distal-type firms, creating a favorable market environment to accelerate the convergence of middle-type firms to the frontier, and encouraging proximal-type firms to innovate to catch up with or surpass the global frontier.