"Population growth and ageing will affect labour supply, economic output, infrastructure requirements and governments' budgets," commission chairman Peter Harris said.
"The best time to develop policies that address the inescapable implications of demographic change is while the transition is in its infancy. It is a good time to start a debate, and to float creative policy options."
The Productivity Commission warning was backed by Treasury top economic forecaster, David Gruen, who told The Australian Financial Review that Australia faces the risk of a sharp growth slowdown, a surge in age-related government spending and a revenue squeeze.
The Productivity Commission report, released on Friday, projected Australia would have four million more people aged 75 years or older by 2060, with 25 centenarians for every 100 newborns, compared with one centenarian for every newborn in 2012.
It said Sydney and Melbourne would each have about seven million residents.
The pension age is set to gradually increase from 65 to 67 by 2023. The Productivity Commission said there was a case to increase the pension age to 70, as people were living longer into retirement.
The commission also proposed an "equity release scheme" for older Australians who own their own homes, to help pay for health and aged-care services.
The scheme would mean those who own their homes contribute half of the annual real increased house value to the government, which would then help cut government spending by about 30 per cent.
"An equity release scheme of this kind would still leave older households with an appreciating asset base and provide a means to increase the quality of services provided over the longer term," it said.
