All you need is a crossover ethernet cable. Manually assign IP addresses (or use ICS as previously suggested) then in the Internet Options/Connections/LAN Settings of the laptop enter your Proxy data.
If you are using DNS, then why on earth are you using HOSTS files? Do you have a DNS server (I don't think that is possible with XP)? Or are you using the DNS servers of your ISP?
I always logon with an ordinary User account. If I need to do "admin things", there's always Run As or as a last resort, logoff, logon as Admin, do whatever needs to be done, logoff, logon as an ordinary User (a bind, I know).
That would be: WinINSTALL LE. This cheap and cheerful version is free and you should be able to find it on the Windows Server CD. \VALUEADD\3RDPARTY\MGMT\WINSTLE