The SIP is meant only for entering information into controls and goes away once it is no longer needed. Making it smaller just makes it harder to use. (Yes... you can use it for input in other ways, like in a game, but really... you shouldnt)

The WP7 emulator is actually quite good. Service calls, Push Notifications, local storage, 3D graphics, etc all work well. There are some obvious things you can't do, like get GPS data, but in general there isn't much you can't do in the emulator. Performance testing should certainly be done on actual hardware of course.