Yes, I would tell the truth, although I'd try to couch it in terms to put the blame on the outfit, not on the person. Of course, you can always hedge your bets with, "I wouldn't choose it, but if you like it, then go for it." After all, what matter is whether that person is pleased with her own looks, not whether she pleases others.

"How do I look?" "Wow. Very interesting!" "Is that good or bad?" "Interesting is good." So you're not saying they LOOK good, you're saying that they're interesting and THAT'S good. Just a little hedging instead of an out and out lie. That's all I can come up with. Otherwise, I'd just say "Fine." and be done with it.

Love you, miss you. Will try to show up sometime very soon.

I like your site. What you write about is interesting.
I think people spend a rather large amount of time obsessed with appearance. What I remember is once a woman approached me and told me that my red flowery-dress was beautiful and she liked the details it had. I thought that those types of comments deserve more thought than the normal "you're gorgeous" etc. When she told me she liked my dress she was commenting about my taste and not my appearance. Everyone is beautiful in their own way. Or that's what I think.
Anyway coming back to your point, if someone asks me how they look and they seem to be prideful about their appearance, why soil it if you think the brown dress makes her look like a paper bag? No maybe you should tell her if it looks that bad... The thing is I don't have the heart to tell someone they look dreadful even if it's true. If a person looks "that bad" in an outfit make suggestions towards a different outfit and assist them in picking one out. I think what Marty said earlier in response draws a good point- if a person is pleased with their looks it doesn't matter what others think.

i agree with everyone above, and with you. it really is a sensitive subject and the bottom line is that we all need to be more comfortable in our own skin and not worry so much what other people think. i hate it that we all want validation from someone else to feel like we are acceptable. selling men's clothes now, i have to be honest... "that's not really a good color for you or, that's cut is not very flattering, etc." if i send them out in a terrible suit and they don't get compliments, they'll never come back!
hugs to you, girlie.