Environmental Regulation, Labor Income Share, and Implications for Inequality

Despite the growing attention to the inequality effects of environmental regulation, little is known about how these policies affect the distribution of income between labor and capital. This paper addresses the gap by examining the effect of environmental regulation on firms’ labor share and the implications for income inequality. Using the National Specially Monitored Firms program in China as a quasi-natural experiment, we employ a regression discontinuity design and find that environmental regulation significantly reduces the labor share of regulated firms by 8.2 percentage points. To explain this finding, we develop a monopolistic competition model where regulated firms adopt clean technologies, increase capital investments, and raise markups, leading to a decline in labor share. Empirical evidence supports the model’s predictions, showing significant increases in capital/labor ratio and markups among regulated firms. Consistent with the decline in labor share, additional analysis based on household survey data reveals a significant rise in income inequality in cities more affected by the policy.