I can't really comment on the boolean rules in the above posts, but I'll try another way to explain how the smart gallery rules work.
I don't think there is any confusion as to how the system currently works. The problem is that the way it works appears contrary to expectations and user requirements. The fact that one of the SmugMug support staff attempted to explain the current behavior using a Boolean expression that matched what we users expect but which is not how it currently works is further evidence of the fact that the current behavior is, at a minimum, not sufficient (to me it seems like a bug).
Second set works similarly but looks at all exclude rules and only contains the photos that match all exclude rules. Example:
EXCLUDE KEYWORD blue
EXCLUDE KEYWORD white
would mean the set would only contain photos that have blue *and* white.
In a final step, the second set of images (from the exclude rules) is removed from the first set (include rules), only leaving photos that are not part of the second set.
Hence the problem: the correct behavior is that any photo with either BLUE or WHITE should be excluded. Clearly, "EXCLUDE KEYWORD blue" must exclude any image with BLUE, while "EXCLUDE KEYWORD white" must exclude any image with WHITE. Otherwise it is impossible to get widely-needed behavior.
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Hence the problem: the correct behavior is that any photo with either BLUE or WHITE should be excluded. Clearly, "EXCLUDE KEYWORD blue" must exclude any image with BLUE, while "EXCLUDE KEYWORD white" must exclude any image with WHITE. Otherwise it is impossible to get widely-needed behavior.