Focusing on employment issues, this paper investigates the impact of government control on state-owned enterprise's (SOE) excess employment, and hence on its performance and the compensation-based incentive mechanism. The results show that the excess employment in SOEs does not result in a substantial increase in labour cost, but a significant decrease in average employees' compensation, including their top managers' unexpectedly. In addition, we find that the government imposed excess employment has significantly reduced the sensitivity of those enterprises' top managers' concern on their compensation over firms' performance. This suggests that negative impact of excess employment is not from the extra labour cost incurred, but from the impairment on compensation-based incentive mechanism, and in turn an increase in the agency cost of management. As such, this paper concludes that effective control of the political pressure is crucial for the success of the reform of SOEs in transition economies, including China.