Why is the patient undergoing a panic attack is asked to breathe in or out from a paper bag?

Rapid breathing in a "panic attack" can reduce the carbon dioxide content and cause what is called a respiratory alkalosis , and eventual alterations in consciousness, fainting, so breathing into a paper bag will cause replentishment of carbon dioxide which will correct the acid/base imbalance in the circulation.

I agree with the other doctors chemical explanation. I also think that it forces the person to focus on something else and this probably also helps. I do not think that this is a very common recomendation any longer.