I've never heard Dago as referring to Italians. Except when it's being used as a general term for everyone on the other side of what the English call the English Channel.

But I can't imagine being offended by this song, if I was Spanish or whatever, any more than I would if it had been Paddy or Mick. That's because the song is conveying a message about a fellowship of the sea which transcends these differences.

There are contexts where I might seriously object to Paddy or Mick, when they are attached to a contemptuous stereotype. It's "horses for courses" - I don't think general rules apply.

That includes general rules like Naemanson's "If you are going to use "dago" in a song to be historically accurate then you should be willing to use the other terms as well and stand ready to take the flak." It's not a question of taking the flak, it's recognsing whether in any particular case it's going to be hurtful to people who don't deserve to be hurt.