Someone beat me to the small valves and chambers comment. You want some heads with the mighty 202s. Smoking at start up is a good indication that the valve guides in those heads are shot anyway. If you have a 2K budged, I'd spend half of it on heads. Get some good aluminum heads, and you're on the right track.

AS for the big block / small block vs. gas milage theory: The best way to get more power from an engine is to improve its EFFICIENCY. When you step up the compression, larger cam, headers, port n' polish, multi-angle valve grind, etc... you are improving the engine efficiency. Until you go to extremes.. and if you are doing a daily driver, then you don't want extremes. Extreme cams wear down, stiff springs stretch the timing chain, etc. If the price of gas is an issue, then build the 350 for 300-350 HP. You don't want a toy you can't afford to play with.