Lack of Sonic hedgehog (Shh) signaling, mediated by the Gli proteins, leads to severe pulmonary hypoplasia. However, the precise role of Gli genes in lung development is not well established. We show Shh signaling prevents Gli3 proteolysis to generate its repressor forms (Gli3R) in the developing murine lung. In Shh(-/-) or cyclopamine-treated wild-type (WT) lung, we found that Gli3R level is elevated, and this upregulation appears to contribute to defects in proliferation and differentiation observed in the Shh(-/-) mesenchyme, where Gli3 is normally expressed. In agreement, we found Shh(-/-);Gli3(-/-) lungs exhibit enhanced growth potential. Vasculogenesis is also enhanced; in contrast, bronchial myogenesis remains absent in Shh(-/-);Gli3(-/-) compared with Shh(-/-) lungs. Genes upregulated in Shh(-/-);Gli3(-/-) relative to Shh(-/-) lung include Wnt2 and, surprisingly, Foxf1 whose expression has been reported to be Shh-dependent. Cyclins D1, D2, and D3 antibody labelings also reveal distinct expression patterns in the normal and mutant lungs. We found significant repression of Tbx2 and Tbx3, both linked to inhibition of cellular senescence, in Shh(-/-) and partial derepression in Shh(-/-); Gli3(-/-) lungs, while Tbx4 and Tbx5 expressions are less affected in the mutants. Our findings shed light on the role of Shh signaling on Gli3 processing in lung growth and differentiation by regulating several critical genes.