Apple did this, with OS X. Microsoft could easily do this, and write the compatibility layer to allow 'legacy' applications to continue running for the next N years.

They don't have the balls to take the risk, though.

Let's be honest here, Apple could only do it because of the relatively small size and loyalty of their user base. Apple users have proven themselves willing to upgrade in a timely fashion. Windows users are more likely to stick with an old version if the new version gets bad press. Think WindowsME and Vista. If Microsoft were to make a complete, compatibility-breaking overhaul, they would have a lot of trouble selling it.

Apple called Microsoft and said "Hey, can you guys port Office to our new OSX thing?" and Microsoft said "Sure, why not? But we're not using Objective-C" Then Apple called Adobe and said "Can you port Photoshop to our new OSX thing?" and Adobe said "OK, but we're not using Objective-C". So Apple made Carbon and their entire legacy ecosystem was more or less a solved problem.

Actually, I think MS's approach here is riskier. By not providing an upgrade path and admitting up front that many things will break they are essentially saying "OK XP users, you will have to do a clean format, reinstall everything, and it will be a pain, but it is worth it because of how amazing Win7 is." Providing a compatibility layer requires fewer balls because people have to make less effort to switch.

Firstly since when is upgrading any OS while skipping a version easy to do? It's even difficult in Linux from what I've seen and experienced.

Secondly there's a migration tool available on the install DVD which saves all of your documents and application settings, meaning that you don't have to spend a lot of time configuring your applications again.

Microsoft already did almost the opposite when they did the switch from .ini files of old to the registry, by translating the .ini file API into equivalent registry calls.

There's no compelling reason why they couldn't do it, although it's probably much more involved than it first appears, and I seriously doubt it's due to the fact "they don't have the balls to take the risk" given many of the security changes introduced in Vista, it's probably just because it's just quite low down on their list of priorities when there's been bigger fish to fry, such as security, performance, and replacing the increasing dated WinForms.