ABSTRACT This study examines the relation between China's household registration (Hukou) policy reform, which relaxed long‐standing institutional restrictions on labor mobility by lowering urban settlement thresholds, and corporate innovation. We find that firms in cities that adopted these Hukou policy liberalizations significantly improve their innovation output. In mechanism analysis, our findings show that the reform affects firm innovation by reducing labor market frictions and improving labor mobility. Moreover, the impact is more pronounced for capital‐intensive firms and those with a higher propensity for R&D investment. These results provide new insights into how removing labor market inefficiencies can enhance the innovative performance of firms in emerging economies.