Fractious domestic politics are at the root of continued poverty in some developing countries and pose a dilemma for donors and international financial institutions. This paper examines the effects of foreign assistance in countries with plentiful investment opportunities when interest groups compete for unproductive government transfers. We assess conditional and unconditional assistance (project and program aid, loans, and grants). We find that project conditionality alone may fail to spur growth. Official development loans channeled to investment may not increase the recipient's growth and welfare even if interest groups are unable to appropriate aid funds directly. Conditions must tackle the domestic drivers of inefficient fiscal policies. To improve the composition of government expenditure, increase growth, and improve welfare, tax rates must be kept constant and loan repayment be financed by cuts in unproductive transfers. Official development grants are superior to loans of the same net present value if donors cannot enforce conditions on assistance.
