"Pennies From Heaven" is a rejuvenating, landmark achievement in the evolution of Hollywood musicals, and certainly the finest American movie of 1981.

A brilliantly enhanced distillation of a British television play shown in 1978, "Pennies" blends the astringent with the poignant and the fanciful. In its tone as well as title, it appears as a belated Hollywood counterpart to Bertolt Brecht's "The Three Penny Opera."

This tragicomic fable is about the downfall of an obscure dreamer, Arthur Parker, played with riveting intensity by Steve Martin. It accumulates emotional impact by contrasting shabby lower middle-class domesticity with glittering fantasy. All the musical numbers emerge from the fantastic sphere and are wittily stylized expressions of the subconscious longings and drives of the characters.

The original author, Dennis Potter, adapted his play to the screen for director Herbert Ross, transposing the setting to the United States during the Great Depression. The plot now unfolds in and around Chicago in 1935, but the characters, events and dramatic devices remain fundamentally unchanged. The filmmakers -- a superlative group that includes such imposing talents as choreographer Danny Daniels, production designer Ken Adam (credited officially as associate producer and "visual consultant"), cinematographer Gordon Willis, costume designer Bob Mackie and editor Richard Marks -- have been true to Potter's vision of a hard-bitten but affecting musical fable located "on both sides of the rainbow."

When you see what's been accomplished in this movie -- on a budget of $20 million, of course, but a $20 million lavished on artistic distinction -- and recall that "Pennies" was the first musical shot at MGM in 16 years and the first original musical shot there in 25 years, you may feel caught between feelings of gratitude for the results and dismay at the thought of all those wasted years.

While "Pennies" may be honestly rejected on its own audacious terms, it shouldn't be expected to satisfy the wrong set of musical expectations. Some people will be unable to accept the stylistic innovation that the musical sequences depend upon -- the use of vintage recordings from the '30s, with the lyrics lip-synced by the cast members. On the other hand, it is an organic dramatic device, inspired by the deepest yearnings of the protagonist, a restless, carnal sheet-music salesman whose outlook is summed up in lines like "I want to live in a world where the songs come true" and "A little capital and a little affection -- it's all a guy needs; it's all America needs."

If you accept the device, I think this movie can take you all the way to rapturous pathos, because you begin to appreciate how varied the musical sequences are and yet how they also add up emotionally. Moreover, the lip-syncing ceases to be mere mouthing; you realize that it's acting, a continuation of the characterizations in another form.

The first shift from dramatic reality to musical reverie is jarring. Martin's Arthur, unable to break down the inhibitions of his prim wife, Joan, played by Jessica Harper, is suddenly isolated miming the words of "I'll Never Have to Dream Again," as sung by Connee Boswell. Although it's a quick introduction to the imaginary framework in which all the songs and dances will operate, there's something instantly compelling about Martin's pantomimic ardor. "Pennies From Heaven" goes on to explore the melancholy fate of a guy who can't cope with reality and escapes into a dream world inspired by pop tunes and movies.

Applying for a bank loan in hope of financing his own record store, Arthur is met with cool contempt by the loan officer, played by Jay Garner. Then, quick as a flash, they've become song-and-dance partners, leading a company of chorus girls into Busby Berkeley patterns across the marble floor of an art deco bank. In his imagination Arthur indulges the fantasy of rolling in dough to the tune of "Yes, Yes! My Baby Says Yes, Yes!"

Danny Daniels seems to respond to each choreographic opportunity with joyous enthusiasm and resourcefulness. There are wonderful production numbers built around every principal character. Bernadette Peters, for example, gets to uncover the playful hedonist in the heroine, a small-town schoolteacher named Eileen Everson who is seduced and abandoned by the philandering Arthur, then reunited in the closing stages of the story. When Eileen's imagination runs wild, her orderly classroom is transformed into a jamboree in white, with Peters vamping to Phyllis Robbins' vocal on "Love Is Good for Anything That Ails You" as the kids wail away on saxophones and trombones.

Although Martin's performance figures to astonish both fans and detractors, Peters contributes the strongest performance in the film. Her Eileen emerges as a psychologically complex mixture of demure and wanton traits, a romantically susceptible girl betrayed by her inability to read the deceitfulness or violence in the men she's attracted to. In one especially moving close-up she seems to reveal and then quickly conceal a sudden fear of Christopher Walken, cast as the sleekly creepy pimp who adds her to his stable after she ends up walking the streets of Chicago.

Peters' character is also used to trigger a sensational dance number headlined by Walken -- a barroom tap routine and striptease choreographed to "Let's Misbehave." This bluntly indecent, wickedly funny brainstorm reveals Walken as a terrific hoofer in several respects. He's nimble and potent right through the wacky payoff, when he strips down to baggy boxer shorts and the huge, absurd valentine tattooed on his chest.

There's rarely a faltering moment in either the dramatic or musical aspects of the presentation. Ross does appear to cut some numbers a bit abruptly and linger a bit doggedly over some dramatic exchanges, but the musical sequences invariably sweep you off your feet.

"Pennies" creates a special quality of pathos, associated with the haunted historical setting of the Depression and heightened by imaginative musical interludes that express more than the rootless characters may be able to convey in words. One of the greatest numbers highlights a virtually inarticulate character, the symbolic figure called Accordion Man, beautifully embodied by Vernel Bagneris. A crazed hobo whose path crosses Arthur's on two fateful occasions, Accordion Man gets his lyric moment while eating in a diner on a rainy night. The facade of the diner is suddenly removed, and Bagneris steps from his booth directly into the downpour. He begins to dance to the title song as rendered by Arthur Tracy, and the rain is magically transformed into a gentle flurry of golden coins.

The filmmakers keep ringing marvelous changes off the convention they've established. In perhaps the most daring and captivating number of all, Martin and Peters are situated in a movie theater watching Fred Astaire and Ginger Rogers begin their somber romantic ballet, "Let's Face the Music and Dance," from "Follow the Fleet." Transfixed, Martin begins moving his lips with the lyrics, but it's a reflex on Arthur's part; we aren't into the fantasy just yet. That occurs a moment later when Arthur leads Eileen onto the stage and they begin duplicating the movements of the movie stars against the lower righthand corner of the screen. At first they're like miniature shadows thrown by the image of Astaire and Rogers. Then they replace the originals and complete the dance, now revised by Daniels to end with a foreshadowing of the arrest that threatens Arthur as soon as he steps back into the real world.

It's a conception that sounds precious but plays like a charm. "Pennies" is so expertly stylized that the classic "quotes" become profoundly stirring. For example, a good deal of the pictorial sophistication possessed by Adam and Willis has been devoted to setting and lighting scenes that reproduce evocative paintings and photographs of the period (more or less), notably famous examples by Edward Hopper, Reginald Marsh and Walker Evans. What makes such reproduction moving is that it makes dramatic sense. Arthur and Eileen really appear to belong in images out of Hopper or Evans.

Potter's writing reveals a remarkably sensitive observer of the human comedy. Although clearsighted and sometimes savagely funny on the subject of his characters' sexual appetites and romantic delusions, Potter also maintains a sympathetic perspective. The characters are no better than they should be, given their circumstances, but we're never encouraged to despise them.

Potter's detachment is humanly generous and dramatically involving. One hopes that "Pennies" will not remain an isolated triumph, because Potter's tale of a forlorn dreamer has inspired a great collaborative effort that promises to reawaken a glorious form of moviemaking.