The incentive problem inherited in bureaucracy is a vital issue in all transition economies and China is not an exception. This paper summarises how China partially solved this problem at early stages of post-Mao reforms and why the Chinese solution is only transitory, which explains severe problems that China is facing now. The paper also discusses the incentive mechanisms in the judicial system; and the effect of the soft budget-constraint (SBC) syndrome on incentives, including the relationship between institutions and innovation.