We have several computers with Outlook 2003 and Office XP, and we have no problems (other than the gotchas that DugaDugDug mentions).
You can certainly use Word's MailMerge, but you might not be able to:
1. Start a MailMerge from within Outlook.
2. Use Outlook contacts as a data source.
3. Merge to e-mail.
But starting a MailMerge from Word to create a Word form letter document, and using, for instance, Excel as your data source, should work just fine.
There were some compelling changes of Outlook between XP (2002) and 2003, enough to make 2003 worth having over 2002. For the rest of the Office suite (Office Standard, at least), I don't find a huge difference between 2002 and 2003 - certainly not enough to invest in new licences.
I would recommend making sure that your user base (and especially management) understands the gotchas that DugaDugDug mentions BEFORE deployment, just to make sure there are no surprises. Some people can get very attached to one particular way of doing things in Office, and may not be happy with a switch. To ease the transition, you could (for instance) disable WordMail on their existing Office deployments, so they get an idea of what the new environment will be like.