We study a one-sector growth model which is standard except for the presence of an externality in the production function. The set of competitive equilibria is large. It includes constant equilibria, sunspot equilibria, cyclical and chaotic equilibria, and equilibria with deterministic or stochastic regime switching. The efficient allocation is characterized by constant employment and a constant growth rate. We identify an income tax-subsidy schedule that supports the efficient allocation as the unique equilibrium outcome. That schedule has two properties: (i) it specifies the tax rate to be an increasing function of aggregate employment, and (ii) earnings are subsidized when aggregate employment is at its efficient level. The first feature eliminates inefficient, fluctuating equilibria, while the second induces agents to internalize the externality.
Published in: _Journal of Monetary Economics_ (Vol. 44, No. 1, August 1999, pp. 3-31) https://doi.org/10.1016/S0304-3932(99)00015-X.