New three-tier methodology accounts for embedded sales tax in supply chains to provide a more accurate estimate of tax expenditure.
ISLAMABAD: The Federal Board of Revenue (FBR) has introduced a revised methodology for estimating sales tax expenditure on exempt local supplies, adopting differentiated adjustment factors that reflect the level of embedded taxation within different supply chains.
The new approach, detailed in the Tax Expenditure Report 2026, aims to provide a more accurate estimate of revenue forgone from sales tax exemptions by recognising that a portion of sales tax is already collected at earlier stages of production and distribution.
Embedded Tax Recognised in Supply Chains
According to the FBR, suppliers of exempt goods are not required to charge output sales tax on their sales. However, they are generally unable to claim input tax credits for sales tax paid on taxable goods and services used during production, processing, transportation, storage and distribution.
As a result, part of the sales tax remains embedded in the cost of the exempt goods and is ultimately passed on to consumers through the final selling price.
To avoid overstating the fiscal cost of exemptions, the FBR has introduced adjustment factors that account for taxes already collected at upstream stages of the supply chain before estimating the net tax expenditure.
The report states that the standard sales tax rate of 18 per cent will first be applied to the gross value of exempt local supplies. The relevant adjustment factor will then be used to estimate the actual tax expenditure attributable to the exempt transaction.
The FBR clarified that imported exempt goods are excluded from this adjustment mechanism because the tax expenditure arises directly at the import stage, where sales tax would otherwise have been collected.
Three-Tier Adjustment Framework
The revised methodology divides exempt local supplies into three categories based on the characteristics of their supply chains.
Tier 1: Essential Food and Agricultural Inputs
The first category carries an adjustment factor of 30 per cent and covers staple food commodities and key agricultural inputs.
These include fertilisers, pesticides, certified seeds, cereals, pulses, fruits, vegetables, milk, livestock products and other essential food items.
According to the FBR, these products typically pass through extensive production, transportation, storage, packaging and distribution processes before reaching consumers. Since significant sales tax is already embedded during these stages, only a relatively small portion of the potential tax expenditure is associated with the final exempt supply.
Tier 2: Healthcare Products
The second category applies an adjustment factor of 40 per cent to pharmaceutical products, medicines, medical devices, dialysis equipment, cardiology products and other healthcare-related supplies.
The FBR noted that these industries involve specialised manufacturing, regulatory compliance, technical processing and controlled distribution networks. While embedded taxation remains substantial, a greater proportion of the overall tax expenditure is attributable to the exempt supply compared with essential food products.
Tier 3: Other Exempt Goods
The third category applies an adjustment factor of 70 per cent to all other exempt locally supplied goods not covered by the first two categories.
The FBR said this factor is consistent with the methodology adopted in previous editions of the Tax Expenditure Report.
Revised Methodology
Under the new framework, exempt supplies will first be classified according to the relevant tier. Sales tax at the standard rate of 18 per cent will then be calculated on the gross value of the exempt supplies before applying the appropriate adjustment factor.
The resulting adjusted values will be aggregated to determine the net sales tax expenditure arising from exemptions on locally supplied goods.
According to the FBR, the revised methodology improves transparency and aligns tax expenditure estimates more closely with economic reality by recognising that a portion of the tax burden has already been collected and embedded within the supply chain before the exempt transaction takes place.