Is urban innovation capacity shaping new models of economic development? Evidence from the circular economy

Circular economy (CE) theory emphasizes that following the reduction, reuse, and recycling (3R) principles can promote the practice of the CE; at the same time, innovative technologies support the feasibility of these principles. However, in academia, it remains unknown whether innovative technologies can be used to effectively implement CE theory. This study estimates the CE performance of 280 cities in China using the super‐efficiency SBM–data envelopment analysis (DEA) model and analyzes the relationship between urban innovation capability (UIC) and the CE using a two‐way fixed‐effects model. The research findings are as follows: First, UIC enhances the CE performance. Second, unlike in green finance, when inclusive finance reaches a certain threshold, the promoting effect of UIC becomes stronger. Third, UIC has both a positive direct effect (local cities) and an indirect effect (neighboring cities). Mechanism tests on improving people's livelihoods, strengthening clean energy development, optimizing industrial structure, and improving agricultural productivity can explain these two effects. Finally, compared with general innovation, the impact of green innovation capability is greater, especially when it comes to green invention innovation. In addition, an innovation‐driven CE shows significant results in terms of carbon reduction and household income. This study theoretically and empirically confirms the driving force of innovation in the CE, providing favorable policy suggestions for countries facing economic transformation, such as China.