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Does foreign aid help develop public institutions and state capacity in developing countries? In this Working Paper, the authors suggest that despite recent calls for increased aid to poor countries by the international community, there may be an aid-institutions paradox. While donor intentions may be sincere, the authors conclude that it is possible that aid could undermine long-term institutional development, particularly in sub-Saharan Africa. By reviewing the evidence of the potentially negative effects of aid dependence on state institutions, the authors provide a thorough analysis of the institutional effects of aid. The conclusions are two-fold: countries which receive a substantial portion of their revenues from foreign aid may be less accountable to their citizens, and they may face less domestic pressure to maintain popular legitimacy. The more aid countries receive from abroad, therefore, the less incentive they have to invest in effective public institutions. From this conclusion, the authors suggest that the donor community consider the aid-institutions paradox when making aid policy. Also, allocating aid toward alternative development activities might be most beneficial. Funding the eradication of endemic diseases, peacekeeping activities, regional or global public goods, and debt relief would most likely side-step the aid-institutions paradox.