This item makes The Duke of Flies a large amount easier, as most of his attacks, which spawn flies, will instantly be converted. Staying out of his way while having Skatole can even make it so he ends up killing himself.
Skatole is a mildly toxic white crystalline organic compound that occurs naturally in feces.
According to Edmund McMillen's First post-Repentance Lore Stream, Skatole's visual was designed first, with McMillen then working backwards to create an appropriate effect to justify an item that puts a poop on Isaac's head.
Skatole was considered as a cosmetic hat for Team Fortress 2, alongside tears, Brimstone, and Tiny Planet. It was dropped as Valve "... didn't want players running around with a wet piece of poop on their heads."