Z-index is not an absolute measurement. It is possible for an element with z-index: 1000 to be behind an element with z-index: 1 - as long as the respective elements belong to different stacking contexts.
When you specify z-index, you're specifying it relative to other elements in the same stacking context, and although the CSS spec's paragraph on Z-index says a new stacking context is only created for positioned content with a z-index other than auto (meaning your entire document should be a single stacking context), you did construct a positioned span: unfortunately IE7 interprets positioned content without z-index this as a new stacking context.
In short, try adding this CSS:
#envelope-1 {position:relative; z-index:1;}
or redesign the document such that your spans don't have position:relative any longer:
<html>
<head>
<title>Z-Index IE7 Test</title>
<style type="text/css">
ul {
background-color: #f00;
z-index: 1000;
position: absolute;
width: 150px;
}
</style>
</head>
<body>
<div>
<label>Input #1:</label> <input><br>
<ul><li>item<li>item<li>item<li>item</ul>
</div>
<div>
<label>Input #2:</label> <input>
</div>
</body>
</html>
See http://www.brenelz.com/blog/2009/02/03/squish-the-internet-explorer-z-index-bug/ for a similar example of this bug. The reason giving a parent element (envelope-1 in your example) a higher z-index works is because then all children of envelope-1 (including the menu) will overlap all siblings of envelope-1 (specifically, envelope-2).
Although z-index lets you explicitly define how things overlap, even without z-index the layering order is well defined. Finally, IE6 has an additional bug that causes selectboxes and iframes to float on top of everything else.