This paper examines the relationship between federal transfers and fiscal deficits in India. The system of federal transfers has been criticized on the grounds that it distorts the incentives for states to promote fiscal discipline. We analyze the relationship between transfers, state domestic product, and fiscal deficit for a panel of states during the period 1990–2010. The paper finds a positive long-run relationship and bi-directional causality between primary/gross fiscal deficits and non-plan transfers. Further, there is a negative long-run relationship and one-way causality between state domestic product and transfers. These results are confirmed by multi-variate cointegration analysis, which finds a long-run relationship between fiscal transfers, state product per capita and the primary deficit of the states. The evidence in the paper is consistent with the system of fiscal transfers being “gap-filling.”