I don't have the experience to accurately answer your question, but until someone else does this is my $0.02. The Mega/Sega CD can perform scaling, rotation (with some limits), and Mode 7 type effects in hardware, and as it has its own RAM it should be able to generate a 256x256 pixel map. Where there may be a question mark compared to the demo is the framerate. The data produced by the CD's ASIC has to be copied into the Mega Drive/Genesis's VRAM before it can be displayed. Theoretically there's only enough bandwidth into the VRAM to manage updating the entire screen with new graphics at 15fps at best, and that doesn't take into account any other overheads. This is seen in quite a lot of ASIC heavy games where either the framerate isn't very good, or they've employed tricks (mirroring to halve the amount of transferred data, for example).
To be fair, the above would likely be true for Mode 7 type effects done in software without the CD too. That may be why the "Mode 7" track in the demo occupies almost exactly half the screen. The real F-Zero's track occupies more of the screen than that, but more data being fed into VRAM would probably reduce the framerate significantly below 30.
Check out F1 Beyond the Limit (or the Japanese version, F1 Heavenly Symphony) for a CD game that uses a Mode 7 style track but with the addition of scaling scenery. The track's probably higher resolution, but it has a lower frame rate.
If you're interested, here are a couple of blog posts by Sarah Jane Avory about Soulstar, which she coded. Visually it is possibly the most impressive game on the system.
