It seems like you've already got a system, frankly. She gives your kid hideous clothes, you sit on them for a while and then get rid of them. It seems kind of harmless, really; there's no harm done, and she's not saying "But where's the glittery top I gave her?? Why isn't she in it???"

She's misguided and has terrible taste, and she may not be very bright or socially skilled. But it seems like you're just spoiling for a fight. Think about holding back. Your kid learns from you. In twenty years, you and she may have somewhat different ideas, and if she is like a lot of people she may find some of your ideas or gifts unwelcome. If you want her to treat you kindly when she's an adult, treat your mother-in-law kindly now. She learns how to treat people by watching you; don't give her any lesson in being hurtful or rude.

Quite honestly, shoving the clothes back at her and telling her you MEAN it, could she just STOP, will hurt her hugely. If that's the goal, go for it. If you'd rather keep peace in the family and teach your child how to accept an unwanted gift graciously . . . accept unwanted gifts graciously.