Well, the problem here is a difference in terminology. Windows reports binary gigabytes (1024 * 1024 * 1024 bytes). Hard drives advertise capacity in decimal gigabytes (1000 * 1000 * 1000 bytes). So, a 40GB drive is really only 37 binary GB (or so). The "OS" on an ipod couldn't possibly take up more than a couple megabytes, at most.
As for sound quality, I read a study where they played 128kbit mp3, 256kbit mp3, and CD on high-end audiophile equipment to a bunch of audiophiles who wouldn't even touch any compressed audio. More than half of them labeled the 128kbit mp3 as CD, but most of them correctly identified the 256kbit mp3s. I once did a test myself and I couldn't tell the difference between a 256kbit and 128kbit on my own speakers (having encoded them both with the same software). So, I don't bother wasting my drive space any more. I actually moved to 64kbit mp3pro because I couldn't hear a difference between that and the 128kbit mp3s.