They already multiplex the 16-bit data bus on top of 16 of the 20 pins of the address bus. But with only 40 pins, that 20-bit address bus was already using half of the total chip pinout.
And, at the time the 8086 was being designed (circa. 1976-1978) with other microprocessors of the time having 16-bit or smaller address buses, the jump to 1M of possible total address space was likely seen as huge. We look back now, comfortable with 12+GB of RAM as a common size, and see 1M as small. But when your common size is 16-64k, having 1M as a possibility would likely seem huge.