Abnormal activation of Hedgehog (Hh) signaling leads to basal cell carcinoma (BCC) of the skin, the most common human cancer. Gli2, the major transcriptional activator of Hh signaling, is essential for hair follicle development and its overexpression in epidermis induces BCC formation and maintains tumor growth. Despite its importance in skin development and tumorigenesis, little is known about the molecular regulation of Gli2. Sufu and Kif7 are two evolutionarily conserved regulators of Gli transcription factors. Here, we show that Sufu and Kif7 regulate Gli2 through distinct mechanisms in keratinocytes. Sufu restricts the activity of Gli2 through cytoplasmic sequestration. Kif7 possesses Sufu-dependent and -independent regulatory functions in Hh signaling: while it promotes Hh pathway activity through the dissociation of Sufu-Gli2 complex, it also contributes to the repression of Hh target genes in the absence of Sufu. Deletion of both Sufu and Kif7 in embryonic skin leads to complete loss of follicular fate. Importantly, although inactivation of Sufu or Kif7 alone in adult epidermis cannot promote BCC formation, their simultaneous deletion induces BCC. These studies establish Sufu and Kif7 as crucial components in the regulation of Gli2 localization and activity, and illustrate their overlapping functions in skin development and tumor suppression.