Change bitrate from the default 128kbps for syncing songs to iPhone
As far as I know iTunes does not offer any other options for bit-rate conversion. This conversion does indeed happen on-the-fly, as you sync your iPhone with iTunes, which makes the syncing take longer but saves space, so you have not to worry for duplicates on your mac.

If space is an issue and you have some spare $25 I also recommend you give a look to iTunes Match: it will allow you to store your music on the Cloud, so you can download the songs as you listen to them thus you have not your huge iTunes library sitting on your iPhone but it still is available when you need it.