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When you set /etc/passwd, it is a URL, so starting with /, it's relative to the current site, which explains that you get a 404 error from the web server.
You need to use the file:///etc/passwd format. Maybe other things too, that's just your immediate issue
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Cross-Site Scripting (XSS) is a client-side vulnerability. It allows you to run client-side code (mostly javascript) on the victims' browser using a vulnerable website. This means using XSS you can not exfiltrate /etc/passwd from the webserver.
To read the arbitrary file from the webserver, the website must be vulnerable to local-file-inclusion (LFI) ...
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XSS is when the attacker can execute its own script inside the context of a different side and thus can act within the origin of this site - hence cross-site scripting.
In your example instead the HTML file gets downloaded to disk due to the Content-Disposition and nothing happens. If the user explicitly clicks on the file to execute it, then it will be ...
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