Factor market distortion has become the main source of many macroeconomic problems and contradictions with social development in China. Capital market distortion, as an important part of factor market distortion, affects the healthy development of Chinas economy and the improvement of social welfare performance. Using China’s provincial panel data and the dynamic spatial panel econometric model, this paper empirically examines the impact of capital market distortion on environmental pollution. The study finds that environmental pollution has obvious spatial correlation and dynamic effect. The distortion of capital market has a significant negative impact on the improvement of China’s environmental quality. The conclusion of this paper provides policy implications for further promoting the reform of China’s interest rate marketization, optimizing the allocation of capital and other production factors among economic entities, and promoting the coordinated and sustainable development of economy and environment.