This paper investigates the potential impact of China’s environmental tax on environmental sustainability. Using a panel data set of 18,888 firm-year observations from A-share listed industrial firms over the 2014–2023 period, we find that the environmental tax decreases firms’ green innovation in the short run. Still, this effect is mitigated where environmental courts have been established. Furthermore, larger, better-educated, and more technologically capable firms exhibited stronger green innovation, while ownership type shows no significant difference. Overall, this study highlights that combining market-based environmental instruments with institutional and capability-based factors is vital for fostering substantive corporate environmental sustainability through green innovation.