On Windows 98 when is it appropriate to use FAT16 rather than FAT32 on a new hard drive?

Almost never. FAT16 restricts the possible file name length to only 8 characters, and doesn't support more than 2 GB maximum. FAT32 supports far larger drives and partitions. There is a slight performance overhead, but if the system can't handle the overhead tolerably, it shouldn't be running Windows 98 anyway.