Financial slack and innovation under environmental regulation

Abstract

This study examines how country-level environmental regulatory stringency influences the relationship between financial slack and firms’ innovation output among firms from the Netherlands, the United States and China. Drawing on the behavioural theory of the firm, financial slack is viewed as both a resource buffer that enables innovation and a potential source of reduced discipline when it becomes excessive. The study uses panel data from listed and formerly listed firms between 2011 and 2020. Firm-level financial and patent data are combined with the OECD Environmental Policy Stringency Index. The hypotheses are tested using OLS panel regression models with industry and year fixed effects and clustered standard errors. The findings show that financial slack has an inverse U-shaped relationship with innovation output in the full sample. This suggests that moderate levels of financial slack are most beneficial for innovation output. Environmental regulatory stringency weakens this relationship, particularly at higher levels of financial slack. However, environmental regulatory stringency is positively associated with innovation output in the successful-innovator sample. Overall, the study concludes that financial slack can support innovation but that its effect depends on regulatory pressure and whether firms already generate patents.