We study how inequality, democracy and economic development affect institutions in a dynamic panel model using data for 78 countries from 1984 to 2006. We suggest a model that assumes the sluggish adjustment of institutional quality and the interplay between the key explanatory variables. We find that democracy has a non‐linear effect on government stability and military involvement in politics. This effect depends on inequality and GDP per capita. Inequality matters for law and order and has a non‐linear effect as well. However, the results for wealth effect are mixed.