On June 9, the city of Chicago’s Department of Finance decreed (PDF) a new tax for the city. Labeled an “amusement tax,” a new 9 percent fee applies to services or engagements undertaken for entertainment purposes, both in person and electronically. And because it applies to online, cloud-based services like Netflix, some also have labeled it a “cloud tax."

The biggest problem with Chicago’s new tax, says Stephen Kranz, a McDermott Will & Emery tax partner, is that it’s illegal — because it wasn’t created by the Legislature. By creating new taxes through city departments not staffed by elected officials, Kranz explained, government can avoid being held accountable for its policies.

Washington state has had a tax on digital content that applies to content streaming from the cloud and otherwise since 2010, but that tax was created by the state Legislature, Kranz said. If the public decides they don’t like that tax or any other things the Legislature is doing, then those elected officials, the mayor, governors and city council members can be voted out of office and replaced by people who will better represent the wishes of the populace.

“Washington," he said, "is a poster child of doing this the right way."

Chicago’s Department of Finance isn’t alone in creating taxes on digital content. The Michigan Department of Treasury and Alabama Department of Revenue have each proposed new taxes on digital content in recent years. Alabama, however, backed down from its proposal on June 8 after public outcry, while Michigan stands by its tax.

“[Michigan’s] department has refused to back down from that position, and many taxpayers are in court — suing and winning in court — against the state,” Kranz said. “My prediction [in Chicago] is that at some point it will get upended. It will either happen like we saw in Alabama, with the Chicago Tax Department concluding that it does not have the authority it claims and backing down from the position, or it will get upended when litigation is filed and a challenge brought to their position through the courts.”

Even the Washington law has faced legal trouble, as the state was sued over the Internet Tax Freedom Act, a federal law passed in 1998 and created to preserve the commercial, educational and informational potential of the Internet, said Neil Bruce, a Paul F. Glaser Professor of Economics at the University of Washington.

No one knows what’s going to happen with Chicago’s new tax, Bruce said, but the complexities surrounding digital goods make enforcement of the tax tricky.

“I don’t think anybody has researched yet what the effects of such taxes would be on the businesses that would be affected,” Bruce said. “But it’s basic common sense in economics that it will cause the firms to adjust to this tax.”

Requests to interview Chicago officials on the matter went unanswered. But adjusting to the new tax in the city might mean that companies move their servers outside the tax jurisdiction, or it might mean consumers find ways to move their billing address or IP address to avoid the tax. Things are complicated further by an issue in the tax world called “nexus,” Bruce said, which means a tax cannot be collected unless the company has a “sufficient physical presence” in the jurisdiction. So a company serving content over the cloud to users in Chicago would need offices or stores in Chicago in order to legitimately levy the amusement tax.

“There’s going to be lots of ways of getting around these laws,” Bruce said.

Several additional states, including New Jersey, South Dakota, Vermont, Colorado, Idaho, Kentucky, Nebraska and Tennessee have laws in place that address the taxation of digital content in various ways. North Dakota and Washington, D.C., are the only U.S. jurisdictions that have specifically exempted the taxation of digital content.