<p>Environmental taxes should hurt business efficiency—but China’s 2018 Environmental Protection Tax reveals the opposite. We examined how this policy transforms enterprise capacity utilization through knowledge creation mechanisms, analyzing Chinese listed companies before and after implementation. The twist? Environmental taxation actually enhances operational efficiency by reshaping how firms acquire and apply knowledge. Two pathways drive this transformation: firms reduce wasteful overinvestment while simultaneously accelerating technological innovation. The most counterintuitive finding emerges in regions with weaker market development, where environmental taxes compensate for underdeveloped institutions by creating alternative pressures that force knowledge-intensive responses. Our results demonstrate that well-designed environmental policies operate as innovation catalysts across systemic, organizational, and individual levels—challenging the traditional trade-off between environmental protection and economic performance. This knowledge-driven approach suggests environmental regulations can serve dual functions: addressing sustainability challenges while building competitive advantages through enhanced learning capabilities. The findings offer new insights for designing market-based policies that leverage knowledge creation to achieve both environmental goals and economic competitiveness, particularly relevant for developing economies seeking sustainable growth pathways in the global knowledge economy. When environmental policy meets innovation strategy, both winners emerge.</p>