The latest intergenerational report shows people will be living longer over the next 40 years but must be prepared to work longer.
Australia's growth and prosperity will suffer unless more older people and women are encouraged into the workforce and government spending is brought under control.
But Treasurer Joe Hockey insists the "best years are ahead of us".
Mr Hockey on Thursday released the latest Intergenerational Report - a five yearly review of Australia's economic direction and the state of the budget spanning 40 years to 2055.
"It is fantastic that Australians are living longer and healthier lives but we need to address these demographic changes," he said.
"If we don't do something, we risk reducing our available workforce, impacting negatively on growth and prosperity, and our income will come under increasing pressure.
"Doing nothing is not an option."
Despite the challenges, the report projects economic growth of 2.8 per cent a year on average over the next four decades.
This would deliver an annual income rise for the average Australian from $66,400 today to $117,300 by 2055.
The report reveals a government aim - which it calls the "proposed policy" scenario - to cap real spending growth at 2.7 per cent a year, return to a budget surplus in 2019/20 and pay off debt by 2031/32.
Once in surplus, the government could then consider in the 2020/21 budget tax cuts to head off "bracket creep", the report says.
Even with a tight rein on spending, the health budget is expected to more than double from $2800 to $6500 per person over the decade, or about 5.5 per cent of GDP.
The ageing population is one of the biggest pressures on the budget, the tax base and services.
The average life expectancy for Australian women and men is expected to be 96.6 and 95.1 years in 2055.
The number of Australians aged 65 and over is projected to more than double by 2055 compared with today, with an expected 40,000 centenarians.
The report suggests that if Australia can get its female participation rate up to Canada's level - which is four per cent higher - the country's GDP could be a permanent $25 billion higher.
For those already in the workforce, boosting productivity will ensure Australia doesn't fall further behind.
Apart from the "proposed policy" scenario, the report sets out two alternative paths.
If the coalition stuck with the previous Labor government's settings, debt would reach $5.6 trillion in four decades and the underlying cash deficit would be 11.7 per cent of GDP.
Spending would blow out to 37 per cent of GDP.
Labor would be expected to ridicule the scenario as being unrealistic and based on false assumptions.
If budget measures stuck in the Senate aren't passed, the report said, the deficit would be six per cent of GDP and net debt $2 trillion. Spending would be around 31 per cent of GDP.
But even the government has shown it's prepared to dump many of the past budget's measures, as seen this week with the Medicare co-payment.
Key findings of the Intergenerational report:
- In 2054/55 there will be about 40,000 people aged over 100 years in Australia compared with just 122 now
- The number of people aged over 65 is expected to double
- The number of people of traditional working age (15-64 years) is expected to fall from 4.5 for every person over 65 to 2.7 people
- The population will be 39.7 million versus 23.9 million
- Average economic growth is expected to slower over the next 40 years than the past 40 years - 2.8 per cent vs 3.1 per cent
- Under current government legislation the budget deficit would 6 per cent of GDP in 2054/55 vs 3.1 per cent ($48.5 billion) in 2013/14
- Under a "proposed policy scenario" the Abbott government expects to improve the budget bottom line to a sustained surplus from 2019/20
- Government debt under current legislation would be 60 per cent of GDP, but under "proposed" policies it would be zero by 2031/32
Read the full report here.