Yes, proprietary software is on the decline. Forget about the free software ideology that holds that free access to code is morally right: businesses have figured out that not only does open source tend to produce better code, it's cheaper to produce it. Economic reality has made even Microsoft to, ever so reluctantly, embrace some open-source projects.
Sure, you have to share the fruits of your efforts in open-source development — but you end up creating better code faster. As many developers have discovered, it's a lot easier to build on top of other programmers' good work than waste time with proprietary software development's constant reinvention of the wheel.
And yes, Microsoft could release a Linux of its own with a Windows Aero-like interface on top of it. Why not? It's not that hard to make a Linux desktop distribution.
Many individuals have made their own Linux desktops. Heck, one of my favorite Linux distributions, MEPIS 8, is pretty much the product of one man, Warren Woodford. Thanks to online Linux distribution building systems like Novell's SUSE Studio, you can even do it yourself even if you don't know gcc, the primary Linux C complier, from make, the tool that takes various source code programs and turns them into an executable program. For that matter, there's already a Linux, the Brazilian BRLix GNU/Linux, whose claim to fame is its Vista Aero look-alike GUI (graphical user interface).
So, will Microsoft actually switch to Linux some day? No. No, they won't.
While it would be simple for Microsoft to make an operating system that looked like Windows but with Linux under the hood, the real problem is all those Microsoft programs, from Microsoft Office to Flight Simulator to Windows Media Player, that require Windows' API (application programming interface) underpinnings. There's the killer technical problem.
But that's not why Microsoft is never, ever going to switch to Linux as its core operating system. The real reason is that Microsoft's business model is all about maintaining and expanding control of the user experience. It's why they illegally killed off Netscape in the '90s (once Bill Gates realized that the Internet mattered) and they locked in hardware vendors to selling only Windows on the desktop. It's why today, to really get the most out of Windows 7 in a business network, you really must have Windows Server 2008 R2 as well.
In Microsoft's ideal world, all your electronics, not just your desktop, are running Windows, and you'll have no choice but to buy new updates every few years. You simply can't do that with Linux, due to its open nature. For example, if you start using Red Hat Linux but end up hating Red Hat, you can easily move over to CentOS or Oracle Unbreakable Linux. With just a little more effort, you can switch from Red Hat to Novell SUSE Linux or Ubuntu. Linux gives you freedom of choice; Windows is built on locking you in.
For that reason alone, Microsoft will never switch. Eventually, Microsoft's business model will fail them. You could argue that its decline has already started under Ballmer's mis-management and the company's slow decline from being the unquestioned ruler of technology to having to share the limelight with Google. But that day isn't here yet. Come the day it does, I don't what Microsoft will do — but by that time, becoming an also-ran in Linux won't be an option.