I was on IRC last night with eadz and he came up with a much simpler approach that I will expand upon now.

He said that he could write a script which would automatically do recursive linking from the /Knoppix cd root tree.
Currently there is a single link to such large directories as /usr to /KNOPPIX/usr. Although this in many ways simplifies things, it also creates problems for those who wish to make changes. If I understand him correctly, his script would automatically create recursive links all the way down the /usr tree for example so that every item is linked instead of an entire directory. This is a crucial first step.

I think that next we would create a directory such as /home/profiles. This is where one could keep diferent root tree profiles for different situations. For instance: /home/profiles/laptop/.root would be the root tree for a laptop (with some of the programs installed plus extras such as a module to run the internel winmodem, modules to activate the special buttons, etc that would be specific to that laptop. You may want another profile such as /home/profiles/generic/.root that would house only the extra programs you would want, etc. These .root trees would only include the extra stuff installed by the user so they do not necessarily need to take up much space. In addition, they could easily be created with the current persistant home program. When the system is loaded (or after a program is installed there) a script is run which will auto load items from the chosen profiles' .root directory on top of the main root tree.

When installing to each profile one could chroot /home/profiles/XXX/.root. So in essence, this may still be small enough to fit on a floppy in some instances, but could easily be run with persistant home from a usb pen drive, etc. The possibilities and portability of this approach would allow for maximum flexibility.

to load the profiles.... maybe have an option at boottime such as:
knoppix profiles
this would then begin the loadup process and after the drive has been discovered and it is ready to write from a profile onto the main root tree, a menu could pop up asking you to choose the profile you wish and list them (in the above scenario you could choose laptop or generic).