Foreign aid effectiveness has become debatable issue in the literature. To accompaniment the concerned literature, this study aims to investigate whether, foreign aid plays any decisive role in worsening or improving income inequality. For the sake of this purpose this study considers the panel data estimation of regression on the relationship between foreign aid and income inequality controlling for other variables. Furthermore, in order to analyze the impact of foreign aid on income inequality it is necessary to recognize the factors which can enhance the effectiveness of foreign aid. In order to achieve this purpose, the study introduces interaction terms between: foreign aid and institutional quality, foreign aid and corruption rate, foreign aid and trade policy, and foreign aid and government policies. The current research encompasses the sample of 43 aid receiving countries covering Asia, Africa, Latin America and Europe, over the period of 1990-2014. In order to overcome the problem of endogeneity, current study employs two-step system GMM. This study concludes that foreign aid improves income inequality though, in smaller magnitude in; Asia, Africa, Latin America, and Europe. Moreover, empirical results of interaction terms reveal that foreign aid effectively reduce income inequality with improvement in institutional quality. However, menace of corruption adversely affect the relationship. Supervisor: Dr. Hasan.M.Mohsin Co-Supervisor: Muhammad Ali Kemal