AbstractIn most of the recent literature on state capacity, the significance of wars in state‐building assumes that threats from foreign countries generate common interests among domestic groups, leading to larger investments in state capacity. However, many countries that have suffered external conflicts do not experience increased unity. Instead, they face factional politics that often lead to destructive civil wars. This paper develops a theory of the impact of interstate conflicts on fiscal capacity in which fighting an external threat is not always a common‐interest public good, and in which interstate conflicts can lead to civil wars. The theory identifies conditions under which an increased risk of external conflict decreases the chance of civil war, which in turn results in a government with a longer political life and with more incentives to invest in fiscal capacity. These conditions depend on the cohesiveness of institutions, but in a non‐trivial and novel way: A higher risk of an external conflict that results in lower political turnover, but that also makes a foreign invasion more likely, contributes to state‐building only if institutions are sufficiently incohesive.