Our empirical findings suggest that environmental regulation as measured by environmental expenditures and revenues from environmental taxation is positively related to (all types of) investment.We also observe significantly negative quadratic terms for both variables, indicating that the costs of compliance with stricter environmental regulation (i.e., higher levels of environmental expenditures and taxes) are above their benefits. For a reasonable range of environmental regulation, however, we may conclude that such regulation is positively associated with country-industry-specific investment in our sample of European countries and industries.

   The paper is organized as follows. In Section 2, we briefly review the related empirical literature. Section 3 derives the empirical investment equation, where a special focus is given to the inclusion of environmental regulation. Section 4 summarizes the data and discusses the variables used in the empirical specification. In Section 5,we present the empirical findings and a sensitivity analysis. Section 6concludes.

2. Previous Empirical Research: An Overview

6. Conclusions

  There is no consensus among environmental economists whether environmental regulation causes a positive or a negative impact on firm behavior. Some authors argue that firms are low cost seekers and, therefore, reduce activities when they are confronted with tight environmental standards (pollution haven hypothesis). Others, in contrast, emphasize the role of (clean) natural resources and innovative technologies in the production process (factor endowment hypothesis and Porter hypothesis). Under this view, environmental regulation should to some extent foster firm activities.

  In this paper we focus on investment decisions and assess how country-industry-specific investment is influenced by environmental stringency. We analyze four types of investment: Gross investment in tangible goods, gross investment in new buildings, gross investment in machinery and productive investments (investment in tangible goods minus investment in abatement technologies). Environmental regulation is measured as (i) total current expenditures on environmental protection, and (ii) revenue from environmental taxation Our data set covers country-industry-specific information from 21 European countries and nine manufacturing industries (food products,beverages and tobacco; textiles and textile products, leather and leather products; wood and wood products; pulp, paper and paper products; coke, refined petroleum products and nuclear fuel;chemicals, rubber and plastic products; other non-metallic mineral products; basic metals and other manufacturing) between 1998 and 2007.

  Our empirical findings allow to derive a consistent picture about the effects of environmental stringency on investment. Both, total current expenditures and revenues from environmental taxation exert a positive impact on all types of country-industry-specific investment. However, the quadratic terms of both variables enter significantly negative, suggesting that the positive effects of environmental regulation are diminishing with tighter restrictions. On average, we find elasticities of about 0.15 for expenditures on environmental protection, and around 0.12 for revenues from environmental taxation. In other words, a 10% increase in expenditures on environmental protection (revenue from environmental taxation) is associated with an increase in (country-industry-specific) investment of about 1.5 (1.2) percent. At first glance, our evidence from European countries and industries seems to contradict the findings of previous U.S. studies.

  The remaining question is how these findings fit into the above mentioned hypotheses regarding the impact of environmental regulation on firm behavior. As far as our country-industry-specific evidence can be inferred to firm-level behavior, the positive parameter estimates on both measures of environmental regulation lend support to the Porter and the factor endowment hypotheses. This positive impact may indicate a comparative advantage that emerges from the efficient use of/handling with natural resources (i.e., higher amount of resources available due to less consumption of resources during the production process, better quality due to less pollution) as a reaction to environmental regulations. However, the negative coefficients of their quadratic terms indicate that both the Porter and also the factor endowment hypotheses do not hold if environmental costs to comply with environmental standards are relatively high compared to their benefits. After all, the evidence presented in this paper does not entirely confirm one of the above mentioned hypotheses on the impact of environmental regulation on investment decisions of firms.