What's the default Notes account setting used for on the iPhone?
Settings > Mail, Contacts, Calendars > Default Account (in the "Notes" section).
What does it do?
I couldn't find any documentation in the user's guide for this setting.
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Each Mail account on your iOS 4+ device is able to sync notes. When you have it enabled for multiple mail accounts you're able to have notes stored in different accounts. The Default Account setting will be for which account the notes are associated with unless you say so otherwise (Identical to the Default mail account in terms of functionality). The screenshot below might help - namely showing the Notes app is like the Mail application - an All Notes (Mail) view and just viewing on the individual accounts.