Endogeneity in the Environmental Kuznets Curve: An Instrumental Variables Approach

A graph of environmental degradation versus income often has an inverted-U shape. Some policy analysts hypothesize that there is a causal relationship between income and environmental degradation, yielding this shape and suggesting that the solution to environmental problems is to alleviate poverty. Others suggest that there are important omitted variables, and that political institutions responding to public demand — and not rising income — improved environmental quality. To examine the relationship between environmental quality, income, and political institutions, we use an institutional variables approach to mitigate the problems caused by simultaneity bias and omitted variable bias. We find causal evidence for an inverted-U relationship between income and environmental degradation for seven out of eleven water pollutants; as well, political institutions have a significant effect on environmental quality for five of the eleven pollutants. The results suggest that both increasing income and improving political institutions reduce water pollution.