Under China’s fiscal decentralization system and the GDP-oriented performance evaluation mechanism, local governments possess strong incentives to attract enterprises for tax base cultivation. Concurrently, environmental decentralization has devolved environmental governance authority to local governments, enabling them to provide “local protectionism” for polluting enterprises through administrative resources to secure fiscal revenues. This institutional arrangement perpetuates reliance on extensive development models, exacerbates market fragmentation, and hinders the entry of non-polluting enterprises while suppressing market vitality. Therefore, how should the environmental management system be restructured to transition from pollution-dependent development patterns and effectively attract non-polluting enterprises?

Using the data of Chinese industrial and commercial enterprise registration from 2009 to 2019 and a DID approach, this paper analyzes the impact of the vertical management system reform of environmental agencies below the provincial level on firm entry. It is found that the reform has a significant impact on firm entry, but the impact is heterogeneous, which is manifested as the inhibiting effect on the entry of polluting enterprises and the promoting effect on the entry of non-polluting enterprises. Mechanism testing attributes this to enhanced investment promotion efficiency, accelerated market integration, and activated green demand effects. Extended findings demonstrate that the reform has a more significant impact on the entry of non-polluting enterprises in cities with a strong border effect, and it is also conducive to changing the pattern of more polluting enterprises congregating in urban border areas in the province.

The contributions of this paper are as follows: First, it extends environmental federalism debates by investigating how China’s vertical management system reform of environmental agencies affects firm entry, addressing persistent scholarly disputes over decentralized vs centralized environmental regulation efficacy. Second, it enriches the firm entry literature through the lens of the institutional design of local environmental governance, contrasting this fundamental and systematic restructuring of power allocation and accountability mechanisms between governments and environmental agencies with temporary environmental initiatives characterized by ad-hoc institutional arrangements and ex-post supervision-oriented approaches. Third, it systematically reveals causal mechanisms between regulatory restructuring and firm entry patterns by analyzing behavioral interactions among local governments, environmental agencies, and corporations, offering policy insights for optimizing vertical management frameworks to enhance environmental oversight and economic vitality.