If you are on this site there is a 99% you think GT5 is great, and it is. However, it is not extraordinary. It has flaws. What a shock. Most of these are actually not all that critical, they are just spotted everywhere. Some have been fixed with a couple megabytes of patches. The most obvious are the blocky shadows and smoke aliasing. Its pretty hard not to notice sitting next what is a stunning game. But in the end they do not ruin the experience.
While observing the game yesterday I found a flaw that I do not think anyone has mentioned or at least in the detail I am about to. Also, I am in no way saying that I expected any of what I am about to say to be in GT5. That would be crazy.
GT5 implemented new smoke effects. They are very nice. If you kick up smoke it has a weight that has been missing for years in the series. It even blows in the wind. And this has lead me to what I think to be one of the biggest visual and immersive flaws in GT5.
Besides the smoke and a few bits of grass, nothing else in the game's environments reacts and acts naturally. And besides the time of day the environmental effects are more on/off. All grass moves. It is not a flat texture. Trees sway in the wind and are more than just two pieces of cardboard stuck together. Snow whips up from the ground and builds up as time passes. Rain is more than a blotch on the windshield and pools where there are changes of surface. Also snow and rain are simply filters put over a screen with added volumetric effects. This may seem like a trivial matter but it is not.
The cars in GT5 are near flawless. But the environments and their lack of effects do not hold up. I feel like the world I am in is static, lifeless. There is no life. There are no birds flying across the sky. No sun glare off of the car in front of me. The 24hr layout of The Ring is the most convincing track because it has life to it. I can't believe I am saying this but it is the smoke from people grilling outside their tents. Like Kaz said, you can almost smell the BBQ. This brings me into the moment.
For the next GT, PD need to think real hard what they want to accomplish. They have a tremendous opportunity to work with the next hardware and create something that is truly extraordinary. Imagine a world where the crowd changed as the race when on. People moved about in the off track area. The clouds, sun, shadows all changed. Bugs hit your windshield and your car got dirty over the course of the race. Imagine racing up Spa and suddenly a plume of fog engulfed the track. Or experiencing a white out at Chamonix. Small waves hitting the port at Monaco. I miss things like the moving crowd on the Gran Canyon track in GT4. Things like this make me feel like I am experiencing something real.
This is what takes out of the world you are in and fools your mind into thinking what you are doing is real. GT5 offers moments of this. In fact it does it better than almost any other game. NFS Shift was not bad, but overdone. It is the essence of what GT is and it is what the next game needs to improve.
If you read all that give yourself a pat on the back.
To all those who are pointing out that the PS3 can only handle so much and has a ancient GPU... really I did not know that tell me more

. I am not saying I expected PD to do all this. I did not say I was disappointed in GT5 because it does not have X, Y and Z. I am simply pointing out a flaw that I believe is very valid. If you read the entire post you would understand that this is more a statement of what PD should work on for the next game if it is on new hardware.
What you're describing is effectively the next generation of graphics, or at least half of it.
For the most part, current AAA titles have been stuck at 2004 graphics; never making it beyond what Valve set out with Half Life 2. The reason for that is because it's just as much a design problem as a graphical problem. Designing the tracks and locations to feel like they're a part of something bigger (people's reactions to City 17 v the fact that you only see 3 corridors and a building of it), as well as the animators bringing life to it's content (facial animation of Alyx and the citizens is why HL2 age extremely well).
There was an interview with the head of Crytek (crytek being famous for making eyeball-melting pretty games and army sims), about what they were doing for the next version of the game engine. They said they wanted to be able to give life to a world; the plants and animals that we see every day but take for granted, because they make the world that much more believable and natural, which is useful for bringing the player into the game.
Some things for other genres that are going to define next-gen graphics are sub-surface scattering (below) and realtime procedural generation for non-crucial assets.
Of course, there are going to be limits.
WARNING SPECULATION AHEAD
Now that the PS3 is snowballing and making SONY lots of golds to hide in their vault, they'll be working on the PS4 pretty hard by now so that they can keep some momentum. Exactly what architecture it has, nobody outside sony knows, but for this example I'll go with something not entirely impossible.
Say it comes out 2012, and the world doesn't end. Judging by the similar specs (relative to the PS3's release date), it could come equipped with a nVidia 600GTX or similar (remember that speculation warning above), and hopefully, an evolution of the cell broadband engine, maybe 12 or 16 spu's instead of 7 or 8 which it has now. Maybe 4Gig of ram, split evenly so half is VRAM.
Even then it's going to have pretty severe limits. The realism and beauty is still going to drop off at a rate proportional to the distance of the object from the camera; no matter the year there's still going to be lower quality stuff further away from the camera and high-quality stuff that's always on-screen (like your car).
The CPU monster could handle the GT5 photomode cars in realtime, maybe 24 of them (maybe more). The massive increase in RAM could handle all the extra AI, as well as massively more complex (and faster) physics and other simulations. Much better trees, spectators, shadows, etc. All animated (preferably by a group of animators kidnapped from Naughty Dog).
For now though, there's not much that can be done. Shadows will probably be improved as time goes by and they find those last few %.
But, provided the gains in PC gaming keep coming the way they do, the next generation of consoles are going to be absolute beasts.
Of course I could be wrong, developers and publishers and manufacturers decide to sit on their hands and make generic fps clones hoping they'll be the next halo or cod and bank of the current wealth of people thinking that their multiplatform console shooters are graphically impressive in any way hatsoever, which means that only a handful of PC-only developers get to show off the above things and what was said in OP's post.