War Economics: The Kargil cess template and market’s irrationality

A significant aspect of the Kargil War was that it marked military modernisation as a financial imperative.

“I have already stated national security is an overriding concern. Its cost has to be shared by all of us. I, therefore, propose to impose a modest surcharge of five per cent across the board on all categories of taxpayers, except individuals and Hindu Undivided Families having total income up to ₹60,000,” is how then finance minister Yashwant Sinha announced the “Kargil cess” in 2002.

In the wake of the terrorist attacks in Pahalgam and the growing possibility of a military response to Pakistan by India, the fiscal and economic implications of a war have gained centre stage.

India’s last major conflict with Pakistan—the Kargil War of 1999—stands out as a point of inflection in more ways than one. For one, it firmly established national security as a financial non-negotiable, even if it required designing and imposing a special tax for specific purposes, including war.

By levying a specific tax, the government ensured that the proceeds would be dedicated to strengthening India's defence capabilities, rather than being absorbed into general revenue.

The introduction of the Kargil Cess reflected the government's recognition of the financial burden of national security. Wars and conflicts require significant resources, and the cost of defending the nation can be substantial. In the case of the Kargil War, the government acknowledged the need for additional funding to address the security challenges posed by the conflict.

The Kargil Cess also underscored the importance of parliamentary oversight in authorising special taxes. The enabling law that specified the purpose of the cess ensured that the funds raised would be used for their intended purpose, providing transparency and accountability in public finance management.

Another significant aspect of the Kargil War was that it marked military modernisation as a financial imperative. The recommendations of the Kargil Review Committee, set up in the aftermath of the war, set in motion significant changes in India's defence policies, including the strengthening of border security measures.

This led to increased defence spending, with a reassessment of budgets resulting in greater funding for military capabilities. The war emphasised the importance of modern equipment and technology in the armed forces, leading to the induction of advanced artillery systems and enhanced training programmes. The government recognised the need for robust intelligence gathering and coordination, which led to the establishment of the Defence Intelligence Agency.

Additionally, the war highlighted the need for robust infrastructure in border areas, leading to the construction of better roads and helipads in high-altitude regions. The conflict also accelerated the integration of cutting-edge technology into military operations, including night vision devices, thermal imaging, and satellite communication systems.

According to the Strategic Foresight Group, a think tank and research organisation, Indian military expenditure rose by 12 per cent in the post-Kargil budget of 2000–2001, followed by a 5 per cent increase in 2002–2003. Though the budget was reduced briefly in 2002–2003, it was raised again by 17 per cent in 2003–2004.

The war also prompted a revision of India's military doctrine, with a focus on rapid deployment forces and improved coordination between branches. The war catalysed significant reforms, emphasising enhanced intelligence coordination and strategic preparedness.

The Indian Army revised its operational strategies to include more flexible and responsive approaches. Furthermore, the war exposed deficiencies in equipment and procurement processes, leading to reforms. The government accelerated the acquisition of advanced weaponry and modernised existing arsenals to better prepare for future conflicts.

Markets and the War Puzzle

The relationship between war and stock prices is complex and counterintuitive. Research suggests that in situations where a pre-war phase precedes the outbreak of conflict, rising tensions can lead to declining stock prices. However, once war breaks out, prices tend to rise.

This pattern reverses when war erupts unexpectedly—stock markets typically fall in such scenarios.

In Markets and Conflict: Economics of War and Peace, William R. Patterson and Daniel W. Kuthy compile research showing that market responses to geopolitical instability are often irrational and short-sighted.

This paradoxical response, sometimes described as the ‘war puzzle’, cannot be attributed solely to uncertainty or ambiguity aversion. Instead, it may reflect the market’s nuanced assessment of the economic implications of war. When war is anticipated, investors may already have priced in its costs, leading to a rally once it begins.

In contrast, surprise wars catch investors off guard, resulting in a more negative market reaction.

India’s experience during the 1999 Kargil War illustrates this. As tensions escalated, the Nifty 50 index fell by 13 per cent in anticipation. However, once the war began, it rallied by 41 percent during the conflict and continued rising thereafter, reinforcing the war puzzle hypothesis.