ABSTRACT: Mesenchymal-epithelial interactions play a critical role in organ development, stem cells and disease. During intestinal development, pseudostratified epithelia undergo dramatic morphogenesis called villification, to form finger-like projections, in which mesenchymal cell clustering and muscle layers play a key role. In the adult, the gut mesenchyme is proposed as a key intestinal stem cell niche providing essential niche signals such as Wnt ligands, while the TGF beta signaling mediated gut stromal program is critical for cancer progression. However, how these signals are produced is currently unknown. In the gut, Hedgehog (Hh) signaling acts strictly in a paracrine manner: Hh ligands are expressed in the epithelium and activate signaling exclusively in the mesenchyme. Notably, Hh signaling is not only essential for mesenchymal clustering and muscle differentiation, it is also involved in intestinal tumorigenesis. To investigate Hh mediated mechanisms, we analyzed mice deleted for key Hh negative regulators, Sufu and/or Spop in the gut mesenchyme, and demonstrated their dosage dependent role in the negative regulation of Hh signaling. Although these mutants exhibit abnormal mesenchymal cell growth and functionally defective muscle layers, villification is completed with proper mesenchymal clustering, implying a permissive role for Hh signaling. These mesenchymal defects are partially rescued by Gli2 reduction, demonstrating the significance of its transcriptional regulation. Surprisingly, in contrast to its known inhibitory role in epithelial proliferation, abnormal Hh activation in the gut mesenchyme leads to increased epithelial proliferation. Corroborating this data, Sufu reduction is sufficient to promote intestinal tumorigenesis, while Gli2 heterozygosity suppresses it. To define GLI2-mediated downstream mechanisms, we mapped its binding sites and analyzed gene expression genome-wide, identifying one of the most robust Hh direct targetome data sets ever reported. This work reveals the GLI2 transcriptional regulation of Wnt and TGF beta pathways in stem cell proliferation and muscle differentiation, providing mechanistic insight into the intestinal stem cell niche in development and tumorigenesis.