How does air pollution affect capital allocation efficiency?

• Examining the problem of capital allocation efficiency in China from the perspective of air pollution. • Constructing a new indicator of capital allocation efficiency, measured using actual capital productivity over potential capital productivity. • Constructing a mechanism for air pollution to affect capital allocation efficiency in terms of innovation activities and human capital accumulation channels. • The effect of air pollution on capital allocation efficiency and its heterogeneity are empirically analyzed. As China seeks to transition to a high-quality economic development model, improving its capital allocation efficiency serves as a means to revitalize the capital stock and facilitate a shift from an investment-driven growth approach to an innovation-driven one. By exploring the relationship between air pollution and capital allocation efficiency, new avenues for promoting high-quality economic development can be identified. This paper develops a theoretical analysis framework that posits the mechanisms by which air pollution affect capital allocation efficiency through innovation activities and human capital channels. Based on the data from prefecture-level cities in China from 2003 to 2019, this paper introduces an innovative method to evaluate capital allocation efficiency. Further, using a panel two-way fixed-effects model to examine the impact of air pollution on capital allocation efficiency and its mechanisms. The findings show that ① the intensification of air pollution reduces capital allocation efficiency and the above findings pass the robustness tests. ② The results of heterogeneity analysis show that there is significant heterogeneity in the effect of air pollution on capital allocation efficiency. The intensification of the air pollution significantly inhibits capital allocation efficiency in inland areas, small and medium-scale cities, after 2013, and in areas with high foreign economic dependence. ③ The results of mechanism analysis shows that the intensification of the air pollution will inhibit capital allocation efficiency by suppressing innovation activities and human capital accumulation channels. [ABSTRACT FROM AUTHOR]