"Tagging" refers to associating each MP3 file, each song, with the appropriate metadata - song title, artist, album, track number, year, genre. In MP3 land, these are the ID2 or ID3 tags that you may see mentioned (there are others, too, but not so common).
It is from those tags that much of the power of the Phatbox is unleashed - if you want to listen to "Classic Rock", then you browse the Genres on the Phatbox (by using the stereo controls and listening to the voice prompts), select "Classic Rock" and the Phatbox will dynamically create a playlist of all songs that have the ID3.Genre tag as "Classic Rock".
Most of the effort is done for you - when you rip your music, the software will connect to an online database, search for the CD you are ripping, and download the necessary tag data - all in a matter of seconds, without you really even knowing. You still have a chance to edit the data yourself before ripping, and even after - the Music Manager software will always let you edit the tag data, so nothing is permanent.
For maximum potential, you need consistency. If you have some songs that are tagged with the ID3.Artist as "Rolling Stones", others as "The Rolling Stones", and yet others as "Rolling Stones, The", then those will all be treated as different artists on the Phatbox. If you want the Phatbox to play all Rolling Stones, it can't really do it on it's own.
Hope that helps; it comes down to just how... particular... you are about the music. Me... I'm pretty particular, and spent hours and hours properly categorizing music, correcting spelling mistakes, and just making sure things were consistent.