Incorporating her taunts into her moveset might be tricky, especially because they have to design the game to be somewhat playable on a single joy con. The way I always imagined Shantae in Smash, pressing any taunt button would put her into dance mode, and then performing any of the Shantae GBC dance sequences would produce a different taunt. Not competitively relevant but a very fun touch. Her down b would be her battle transformations, which would work just like dancing in Risky's Revenge - you cycle through dance moves, and then stop on a particular dance move to perform the desired transformation.
Your idea on the other hand is more creative, and would definitely push the envelope more. Whether it would actually work well is hard to say without trying it out, but it would certainly make for a unique fighter concept.
Can I also just say, it's so refreshing to be past the 3DS / Wii U era when every character idea was constrained by whether or not the 3DS could handle it. No limits on Shantae's transformations now!
Stating whether dancing is a good fit for the games or not starts to get into more subjective territory. Some might reasonably feel that it adds a tedious and repetitive interruption to the gameplay. Others might feel with equal justification that fusing in a little rhythmic mini-game enhances the experience, and adds a sense of skill and immersion to what would otherwise be a fairly bland mechanic.
One interesting aspect of game design is how designers give players some choice over the type of challenge they face by rewarding different skills. This video does a good job discussing this (skip to 12:30ish for the relevant part):
https://www.youtube.com/watch?v=p9NdAao9y_4. To summarize, Mario games reward platforming skills of course, but they also reward both more skilled and less skilled players for exploring the level. More skilled players who choose to explore can find extra-challenging sequences that yield extra coins or collectibles. Less skilled players who choose to explore can find secret shortcuts to circumvent challenging parts of the levels.
Analogously, Shantae games could reward both platforming skills and manual dancing in a similar way. Players less skilled at platforming could ease the challenge in tricky sections with a well-executed dance, whereas more skilled players will be able to leave dancing on auto and get by on their platforming skills alone.
For those who prefer auto dancing, but also don't want a huge platforming challenge, this compromise would still work out pretty well, since you could still auto dance through most of the game without noticing much of a difficulty penalty. I wouldn't worry that balancing the game this way will make manual dancing feel pointless to players who like it - just receiving the movement/damage buffs will feel rewarding enough for players to have fun executing a mechanic they already enjoy, even if they don't really need its help to get through most areas.
Perhaps sprinkle in a small number of strictly optional sequences throughout the game that require both a big dance buff and a deft platforming hand, as a treat for players who enjoy both manual dancing and punishing platforming challenges.
You may be right that it's a fine line, but if executed well, I think this would be an interesting and fun take on player-controlled dynamic difficulty adjustment.
I am intrigued by your suggestion to think bigger and make Shantae's transformations as versatile as a Kirby copy ability though. Can you elaborate on what you mean by this?