JAmes reckons:
Graphics supposedly getting worse with damage? Less cars? Lets just assume PS3 will be fine with damgage to a very realistic degree with many cars... So I'll assume damage is purely a gameplay design issue in the next gen (whether its fun etc).
The ultimate (for me):
Full realistic damage, so the car just wraps around a tree and is a complete write-off. Hardcore damage. For this to work, the AI MUST have a strong sense of self preservation (we'll probably be racing online for GT5 so humans will be careful of their cars hopefully... and this negates the AI issue to some degree). However actually crashing badly shouldn't be any more common than it is in real life racing (quite rare). How to achieve this is easy I reckon. Just make sure the handling gives good feedback so you don't get unfairly surprised at what the car does, excellent control (good driving wheels etc), smart AI that gets out of the way to avoid crashes (even TOCA 1 on PS1 would swerve off the track if you tried to do head-ons with it..), and most importantly track design where you can see the damn edge of the track and can properly judge corner radiuses etc. ie good vision, minimal blind corners, no stupid dark tracks at night (PGR2/NFS I'm looking at you). Serious car racing should be done with good visibility ideally.
Make it easy to drive sensibly and not get damaged (AI doesn't actively smash you like Forza), but if you push REAL hard it gets way more risky (like IRL) and if you do crash, you know it was YOUR fault and the car is damaged to the proper degree (a lot). You can use smashed cars for parts, etc- good idea.
It would be fun (perhaps) to have to take your car to the "GT auto wreckers" where it gets smashed into a tiny metal cube and you get some money for the scrap metal and parts (PD would never get Ferrari under this arrangement HEHE

). I can see this being done very cutely ala the car wash/oil change screens in GT4!
Maybe have some kind of insurance you can buy that gets way less expensive if your careful and don't write off many cars and vice-versa... this would be a good way around the player potentially losing too much cash if the smashed car was really expensive. It would be a fun risk to choose to not buy the insurance, hoping to improve your earnings etc!
Cars that are not write-offs and just have minor damage will have to be taken to the "GT auto panel beaters" and get fixed for free if you have insurance but for a certain fee otherwise.
This whole system would make the crappy cheap second-hand cars much more appealing (a good thing!) as they would not cost much to buy so damage wouldn't worry the player as much. Insurance would be cheaper etc. So hotting up cheap cars to stupid degrees to compete against faster cars would be a good idea!! (you keep the expensive mods in the event of a write-off remember) There's actually a valid gameplay point to the old cars then, not just nostalgia!!
Also there would be a point to the insanely big garage in GT, and overall massive numbers of cars in the game you end up owning (many not even driven) - a bad driver would write-off a good number of them, and hence NEED them all! Except the 80's volvo that would be indestructible for a joke. A bad player would NEED that many skylines. Smash. Crash. Scrape! Oh no not another one gone to the big car afterlife in the sky. Oh dear. I stress though a GOOD player and serious sim-racer should be able to avoid write-offs and only get minor scrapes, dents if they are battling for position etc.
I stress I don't want it to be burnout 3, but if you want to write-off a skyline you should be able to. It should literally decrease the number of skylines in the game, so that it is actually possible to write them all off so that they are completely gone. YES! I am talking about a FINITE number of cars of the same model in the game. So you can buy all the Aston Martin DB9s (say 10 of them in the game) and have to be really careful with them (this would make you treasure your nice cars so much more, making the player feel much more like they actually OWN the car and want to look after it...). GT can feel like each car isn't special as you can just endlessly buy more. You should be able to buy all the skylines for example and just write them all off. This is a more common car so there would be more of them naturally (60 or something). So the more exotic cars would ACTUALLY be more rare and therefore get the red carpet treatment from players! YES! I would like the player to actually say "well maybe I won't take the Maybach rallying dear.. I think I won't risk it.".
OK so I know most of you wouldn't like my idea of finite numbers of cars of the same model that can all get wrote-off.. BUT here's the fix to your worries. Say you smashed all the skylines, after a certain (very substantial) number of game days, there would slowly appear additional skylines in the Nissan dealer as new ones are shipped to the dealer (so that it wasn't possible to NEVER be able to race a skyline again). It would be like Nissan literally had to make more of them for you.
This philosophy carries through to old cars that aren't made anymore slowly reappearing in the used cars section, but really old rare ones like a merc gullwing, if you crash that you should only get maybe one more...merc can't just make more of them! It would make you feel closer to your cars and treasure them more, as well as letting you get your own back on models you don't like!
More likely system PD will use:
PGR2 style cosmetic damage that just gets repaired automatically (fee taken from earnings). Minimal change to GT style gameplay.
Or Colin McRae style damage where damage stays damaged (and affects the actual performance of the car) for the life of the car unless you fix it. In GT they would never make it so that a car got so damaged it was completely undrivable though, otherwise the trademark GT style gameplay would be affected too much.
Lets assume PD have no balls to significantly change the way GT plays, and they will do the easiest way of implementing damage that Kaz is happy with. Probably just cosmetic with or without some form of limited mechanical damage due to many manufacturers, licensing etc.
Oh well I like my idea better.