Nobody guessed it! Lots of talk along the right lines, though. In Loonyland 2, things change from the 'zelda' style of collecting powerups to a much more RPG style. You gain XP from killing monsters (actually most of them are evil animated toys for plot reasons), level up, and earn Skill Points. You spend the skill points upgrading 40 different skills. You never get enough skill points to come anywhere near maxing out all of the skills (as you can see in the picture, an individual skill can go up to 10), so you really have to decide what you want to focus on. The one nod to non-RPG style is that you have to find or earn a Skill Scroll before you can put points in a skill.
The skills are divided into 4 sets: Passive (boost stuff generally - skills like Strength, Endurance, and Dodge), Attack (special attacks and modifiers for your normal axe attacks - skills like Axe Mastery, Stun, and Poison), Throwing (special attacks and modifiers for throwing your axe - skills like Multishot, Ricochet, and Piercing), and finally of course Magic (magic spells like ... well, I don't have them in front of me, but you can imagine, it's magic).
In the shot, you can see how the skills look. I'm excited because I just implemented Stun, and it's fun to stun guys. I'm going through and implementing all the skills in order before doing anything else. As you can see, attacking costs Stamina, which recovers quickly, but if you upgrade your skills too much, your attacks will be very expensive. So you'll need to upgrade Endurance to counteract that. Another way to help it is to upgrade Toughness, which gives you more life, because your maximum Stamina is always your current life (so getting injured weakens your ability to attack - but upgrading Endurance lets you keep more of your Stamina as you get injured, too). So there are a lot of skills to interact with and decide on.
And by the way, in Loonyland, they celebrate Festivus, not Christmas!