Do tight environmental regulations cause economic contraction? Panel evidence from the European countries

Developed countries have long tried to increase their environmental standards to mitigate the negative effects of economic activities. For this purpose, they impose environmental taxes, energy taxes, and emission limits. In the last decade, a new measurement technique for environmental policy was introduced: the Environmental Policy Stringency Index (EPS index). This index takes values from 0.00 to 6.00, and higher values refer to more stringent environmental policies, whereas lower values suggest lax policies. This study aims to explore the impact of the EPS index on economic activities at the aggregate and sectoral levels for 20 European countries covering the period 1995–2020. For this purpose, this study utilizes the dynamic panel data approach, the two‐step system generalized method of moments (GMM) estimation method. The empirical findings show that an increase in the EPS index causes a decline in economic growth at the aggregate level. At the sectoral level, it was found that the industry sector is negatively affected by increases in environmental standards. In addition to the system GMM results, this study employs the Dumitrescu–Hurlin panel non‐causality test to detect causal linkages between variables. The empirical findings show that the EPS index Granger causes economic activity in almost all sectors. The empirical results indicate that environmental regulations should be carefully designed to prevent economic contraction. Policymakers need to develop policies to decrease dependency on fossil fuels in industrial production. Thus, they can subsidize firms to invest in productive and innovative areas.