Environmental Regulation Stringency and Allocation between R&D and Physical Capital : A Two-Engine Growth Model

Many studies have identified the negative effect of environmental regulation on capital accumulation and the positive effect on innovation. This observed capital-innovation tradeoff due to environmental regulation lacks theoretical underpinning. We fill this gap by developing a unified two-engine endogenous growth model with environmental regulation. We show that a stringent environmental policy (in terms of the pollution tax) leads to a sectoral reallocation from the dirty inputs to the clean final-good sectors, which increases the demand for R&D and activates the in- novation engine. The capital engine depends on the elasticity of substitution between the polluting and capital inputs. If both are sufficiently complementary, capital accumulation slows down. An- other novelty of our model is that the contrasting responses of the two growth engines can lead to an inverted-U relation between the overall GDP growth and environmental taxation. Our calibration shows that a well-designed environmental regulation can achieve “double dividend”: both improving the environment and enhancing economic growth and social welfare. Our empirical analysis provides a macro-level evidence to justify our model prediction using the cross-country panel data