I couldn't even support such an idea in principle. For me, one of the cornerstones of XML's value is in completely determining the lexical space. I think leaving entity interpretation to applications would kick a huge hole in that.
Actually, it strikes me as quite an intelligent layering. If xinclude processing can be done in a different layer from XML parsing, why not entity expansion? In fact, it's strongly arguable that it SHOULD be a separate process; one of the use cases for entity expansion is to give a level of indirection so that the same entity reference can be replaced by different text at different places/times, and that works much better if it isn't embedded in the parser.
Well you can find plenty of debate about XInclude and its separate layer, and it distinctions from general entities. Not something I really feel like going into. I am, however, surprised that you say that replacing the same entity reference with different text at different places in the document is a use-case. That's news to me, but it is a use-case that suits elements rather than entities.
