Devices with capacitive touchscreens are made to be operated with your fingers. Once a target is smaller than 44x44 points, it becomes very hard to hit accurately. That's why screen size is important for tablets. A 10" tablet can simply accommodate more UI elements than a 3,5" or 7" screen, and thus you can use more complicated programs on them.
That's a fair point. But in practice the target sizes on typical iPad apps aren't close to the lower limit of practicality, and the UIs of such apps are constrained more by not being ugly and confusing than by how many touch targets can fit on the screen.
Hence, e.g., all the speculation that Apple will produce an 8" tablet that's basically an iPad 2 scaled down somewhat, to have the same pixel size as the (old) iPhone -- whose target sizes don't seem to be too small.
I agree and Gruber wrote a good post about that [1]. However, if Apple releases a smaller 7.85" iPad, it will still have a 40% larger screen area than 7" tablets do [2].
