How is the initial size or height of an annotation determined? What exactly is the size that text height multipliers are multiplying against?
The default size of an annotation (with height multipliers set to 1.0) is 0.1 inches in height when printed/plotted. This is to match the standard Leroy Lettering size that a draftsman uses for "new" work.
Since the default plot scale is set to 1 inch = 40 feet (Tools > Options > Drawing), the initial height of an annotation will be 4 ft. If you change the plot scale, the text size seen in plan view will scale accordingly to achieve that 0.1 inch standard height.
If you then adjust the height multiplier in either the properties of the annotation or in the global height multiplier setting (Tools > Options > Drawing), the size will be adjusted accordingly. For example a height multiplier of 2.0 will make the 4 foot high text 8 feet high.
Changing symbol size, text height, or line width for elements in a model