Insert contents of a file after specific pattern match
Try following command:
sed '/<tag>/ r file2.txt' file1.txt
It yields:
<html>
<body>
<tag>
Hello world
</tag>
</body>
</html>
EDIT for explanation why your command doesn't work as you want: The r filename command adds its content at the end of the current cycle or when next input line is read. And you are using the N command which doesn't print anything but reads next line, so at that time Hello world is printed and after that the normal stream of lines.
In my case, it reads line with <tag>, then ends cycle, so prints the line and after it the content of the file and carry on reading until the end.