Hey'a Pete welcome to the forum,
The higher quality setting you choose the better the playback will be regardless of the resolution of the input video resolution. I'm not familiar with VHS resolution, but I do know that if you try to capture it at 640x480 or higher, you get better results with the final product. Keep in mind that the highest quality setting - 720x480 is not a standard VHS or 4:3 aspect ratio. If you try to capture VHS at 720x480 things will not look right as this is not a native aspect ratio when it comes to VHS.
Any time you convert video, you lose some quality. This is common with any capture device. The higher quality capture device, the less quality you will lose. It's normal that your captured video quality won't look quite as good as the original. You will always lose some quality.
MPEG-4 allows you to capture close to MPEG-2 quality with a smaller file size. If you're planning on keeping the files on CD in DivX format, MPEG-4 is the way to go. If you have a DVDRW and plan to make DVD movies, it's best to stick with the DVD Video format of MPEG-2. If you are looking for space, then go with MPEG-4.
I hope this is helpful. If you have any more questions, please ask!