by all means, do it. you really need some more RAM, though. Max that baby out.
the HD also needs upgrading, but 4GB will fit it on there.
get more RAM and HD space as soon as you can.
the OS will feel about as responsive as OS 9, honestly. I've seen Panther run on the same hardware and I have no complaints. video isn't so hot, though. there's some video acceleration, but it's not the greatest on those old Rage Pro cards.
As for OS 9, it doesn't have to go anywhere at all. OS X and OS 9 can be installed side by side, on the same partition, there's no issues whatsoever.
my vote is to do it. back up everything and just wipe the drive. that's not my usual suggestion, but it'd be best so that you can be sure to have enough space.
when you install Panther, do a custom install and leave out everything but the required Core System Software and the BSD Subsystem. You can go back and add the other bits as you want them. The iApps will honestly be too slow to enjoy, so don't bother installing them.